Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that NeoPhotonics Corporation (NYSE:NPTN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does NeoPhotonics Carry?
As you can see below, NeoPhotonics had US$36.1m of debt at June 2020, down from US$47.9m a year prior. But on the other hand it also has US$105.0m in cash, leading to a US$68.9m net cash position.
A Look At NeoPhotonics's Liabilities
We can see from the most recent balance sheet that NeoPhotonics had liabilities of US$110.1m falling due within a year, and liabilities of US$59.5m due beyond that. Offsetting these obligations, it had cash of US$105.0m as well as receivables valued at US$70.7m due within 12 months. So it actually has US$6.08m more liquid assets than total liabilities.
This state of affairs indicates that NeoPhotonics's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the US$336.1m company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, NeoPhotonics boasts net cash, so it's fair to say it does not have a heavy debt load!
Although NeoPhotonics made a loss at the EBIT level, last year, it was also good to see that it generated US$20m in EBIT over the last twelve months. 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 NeoPhotonics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While NeoPhotonics 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. Over the last year, NeoPhotonics actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to investigate a company's debt, in this case NeoPhotonics has US$68.9m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$49m, being 248% of its EBIT. So we don't think NeoPhotonics's use of debt is risky. 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. Be aware that NeoPhotonics is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...
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.
This article by Simply Wall St is general in nature. 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.
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