Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Rockwell Automation, Inc. (NYSE:ROK) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Rockwell Automation's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Rockwell Automation had US$3.67b of debt in March 2024, down from US$3.99b, one year before. However, because it has a cash reserve of US$470.5m, its net debt is less, at about US$3.20b.

How Healthy Is Rockwell Automation's Balance Sheet?

The latest balance sheet data shows that Rockwell Automation had liabilities of US$3.70b due within a year, and liabilities of US$3.94b falling due after that. On the other hand, it had cash of US$470.5m and US$1.96b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.21b.

Since publicly traded Rockwell Automation shares are worth a very impressive total of US$31.4b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Rockwell Automation's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 12.7 times its interest expense, implies the debt load is as light as a peacock feather. We saw Rockwell Automation grow its EBIT by 3.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Rockwell Automation'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Rockwell Automation recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Rockwell Automation's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. All these things considered, it appears that Rockwell Automation can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Rockwell Automation .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com