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 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. We can see that American Woodmark Corporation (NASDAQ:AMWD) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is American Woodmark's Debt?

The image below, which you can click on for greater detail, shows that American Woodmark had debt of US$371.3m at the end of January 2024, a reduction from US$440.7m over a year. However, because it has a cash reserve of US$97.8m, its net debt is less, at about US$273.5m.

A Look At American Woodmark's Liabilities

The latest balance sheet data shows that American Woodmark had liabilities of US$188.3m due within a year, and liabilities of US$488.6m falling due after that. On the other hand, it had cash of US$97.8m and US$113.1m worth of receivables due within a year. So its liabilities total US$466.0m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since American Woodmark has a market capitalization of US$1.47b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

American Woodmark's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 17.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, American Woodmark grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if American Woodmark can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, American Woodmark recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

American Woodmark'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 the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think American Woodmark's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of American Woodmark's earnings per share history for free.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.