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We believe AO Smith (NYSE:AOS) can manage its debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, “The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.” When thinking about how risky a particular stock is It may be obvious that you need to consider debt, because too much debt can ruin a business. We take note of that A. O. Smith Corporation (NYSE:AOS) has debt on its balance sheet. But the real question is whether this debt makes the company risky.

When is debt dangerous?

Generally speaking, debt only becomes a real problem when a business cannot easily pay it off, either by raising capital or with its own cash flow. If the company can’t meet its legal obligations to pay down debt, shareholders could end up with nothing. However, it is more common (but still costly) for a company to have to issue shares at bargain prices, resulting in permanent shareholder dilution, just to shore up its balance sheet. However, the most common situation is for a company to manage its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first consider cash and debt together.

Check out our latest analysis for AO Smith

How much does AO Smith owe?

You can click on the graphic below to see the historical numbers. However, it shows that AO Smith had $119.7 million in debt as of September 2024, compared to $129.6 million a year earlier. However, the company has cash of US$255.6m, leading to net cash of US$135.9m.

Debt-Equity History Analysis
NYSE:AOS Debt to Equity History December 5, 2024

How strong is AO Smith’s balance sheet?

The most recent balance sheet shows that AO Smith had liabilities of US$844.2m within a year, and liabilities of US$393.3m beyond that. Offsetting these obligations, it had cash of US$255.6m as well as receivables valued at US$558.2m due within 12 months. So its liabilities exceed the sum of its cash and (near-term) receivables by US$423.7m.

Of course, AO Smith has a whopping market capitalization of US$10.7b, so these liabilities are probably manageable. However, we believe it is worth keeping an eye on balance sheet strength, as it can change over time. Despite its significant liabilities, AO Smith has net cash, so it’s fair to say the company doesn’t have a huge debt load!

AO Smith’s EBIT was pretty flat last year, but that shouldn’t be a problem as the company doesn’t have a lot of debt. The balance sheet is clearly the area you should focus on when analyzing debt. But it is future profits, above all, that will determine whether AO Smith can maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay off its debts with paper profits; it takes cash. While AO Smith does have net cash on the balance sheet, it is still interesting to see how well the company converts its earnings before interest and tax (EBIT) into free cash flow, as this will influence both its need and capacity to manage debt. Over the last three years, AO Smith recorded free cash flow worth 69% of its EBIT, which is about normal given that free cash flow excludes interest and tax. That ready cash means it can pay down its debt whenever it wants.

In summary

We could understand if investors are concerned about AO Smith’s liabilities, but we can be reassured if it has net cash of US$135.9m. And it impressed us with free cash flow of US$484m, which is 69% of its EBIT. Therefore, we don’t think AO Smith’s use of debt is risky. Over time, stock prices tend to follow earnings per share. So if you’re interested in AO Smith, you can click here to see an interactive graph of its earnings per share history.

Ultimately, sometimes it’s easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with no net debt 100% freeat the moment.

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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term focused analysis based on fundamental data. Note that our analysis may not reflect the latest price-sensitive company announcements or qualitative material. Simply Wall St has no positions in any stocks mentioned.

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