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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, AAON, Inc. (NASDAQ:AAON) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for AAON

What Is AAON's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 AAON had US$76.3m of debt, an increase on none, over one year. However, it also had US$10.7m in cash, and so its net debt is US$65.6m.

How Strong Is AAON's Balance Sheet?

The latest balance sheet data shows that AAON had liabilities of US$142.2m due within a year, and liabilities of US$119.8m falling due after that. Offsetting this, it had US$10.7m in cash and US$145.6m in receivables that were due within 12 months. So it has liabilities totalling US$105.6m more than its cash and near-term receivables, combined.

Since publicly traded AAON shares are worth a total of US$4.02b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

AAON's net debt is only 0.55 times its EBITDA. And its EBIT covers its interest expense a whopping 47.6 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, AAON grew its EBIT by 3.6% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if AAON 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, AAON recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

AAON's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that AAON can handle its debt fairly comfortably. 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. We've identified 2 warning signs with AAON (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.