Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies A. O. Smith Corporation (NYSE:AOS) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does A. O. Smith Carry?

The image below, which you can click on for greater detail, shows that A. O. Smith had debt of US$140.4m at the end of June 2024, a reduction from US$206.0m over a year. However, it does have US$233.3m in cash offsetting this, leading to net cash of US$92.9m.

How Healthy Is A. O. Smith's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that A. O. Smith had liabilities of US$872.4m due within 12 months and liabilities of US$413.6m due beyond that. On the other hand, it had cash of US$233.3m and US$649.9m worth of receivables due within a year. So its liabilities total US$402.8m more than the combination of its cash and short-term receivables.

Since publicly traded A. O. Smith shares are worth a very impressive total of US$12.7b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, A. O. Smith boasts net cash, so it's fair to say it does not have a heavy debt load!

Fortunately, A. O. Smith grew its EBIT by 8.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine A. O. Smith'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, a company can only pay off debt with cold hard cash, not accounting profits. While A. O. Smith has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, A. O. Smith produced sturdy free cash flow equating to 69% 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.

Summing Up

We could understand if investors are concerned about A. O. Smith's liabilities, but we can be reassured by the fact it has has net cash of US$92.9m. And it impressed us with free cash flow of US$481m, being 69% of its EBIT. So we don't think A. O. Smith's use of debt is risky. Another factor that would give us confidence in A. O. Smith would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.