Is ADVA Optical Networking (ETR:ADV) Using Too Much Debt?

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, ADVA Optical Networking SE (ETR:ADV) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for ADVA Optical Networking

What Is ADVA Optical Networking's Debt?

As you can see below, ADVA Optical Networking had €62.6m of debt at December 2020, down from €81.0m a year prior. However, its balance sheet shows it holds €66.4m in cash, so it actually has €3.81m net cash.

A Look At ADVA Optical Networking's Liabilities

According to the last reported balance sheet, ADVA Optical Networking had liabilities of €130.6m due within 12 months, and liabilities of €106.1m due beyond 12 months. Offsetting this, it had €66.4m in cash and €88.0m in receivables that were due within 12 months. So its liabilities total €82.3m more than the combination of its cash and short-term receivables.

Since publicly traded ADVA Optical Networking shares are worth a total of €493.9m, 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, ADVA Optical Networking boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that ADVA Optical Networking has boosted its EBIT by 60%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ADVA Optical Networking'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. ADVA Optical Networking may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, ADVA Optical Networking generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While ADVA Optical Networking does have more liabilities than liquid assets, it also has net cash of €3.81m. And it impressed us with free cash flow of €39m, being 92% of its EBIT. So we don't think ADVA Optical Networking'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. We've identified 1 warning sign with ADVA Optical Networking , and understanding them should be part of your investment process.

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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