Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Watsco, Inc. (NYSE:WSO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Watsco's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Watsco had US$219.6m of debt, an increase on US$143.5m, over one year. However, it also had US$55.9m in cash, and so its net debt is US$163.7m.
A Look At Watsco's Liabilities
We can see from the most recent balance sheet that Watsco had liabilities of US$580.5m falling due within a year, and liabilities of US$418.6m due beyond that. Offsetting these obligations, it had cash of US$55.9m as well as receivables valued at US$655.4m due within 12 months. So it has liabilities totalling US$287.7m more than its cash and near-term receivables, combined.
Of course, Watsco has a market capitalization of US$6.22b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Watsco's net debt is only 0.43 times its EBITDA. And its EBIT covers its interest expense a whopping 106 times over. So we're pretty relaxed about its super-conservative use of debt. While Watsco doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Watsco's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Watsco produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Watsco's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Watsco is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Watsco's dividend history, without delay!
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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