These 4 Measures Indicate That Cyanotech (NASDAQ:CYAN) Is Using Debt Reasonably Well

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Cyanotech Corporation (NASDAQ:CYAN) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Cyanotech

What Is Cyanotech's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Cyanotech had US$9.74m of debt, an increase on US$9.08m, over one year. On the flip side, it has US$4.25m in cash leading to net debt of about US$5.49m.

How Strong Is Cyanotech's Balance Sheet?

According to the last reported balance sheet, Cyanotech had liabilities of US$8.01m due within 12 months, and liabilities of US$8.94m due beyond 12 months. Offsetting these obligations, it had cash of US$4.25m as well as receivables valued at US$2.08m due within 12 months. So its liabilities total US$10.6m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Cyanotech has a market capitalization of US$22.6m, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Even though Cyanotech's debt is only 2.1, its interest cover is really very low at 1.2. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Pleasingly, Cyanotech is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 394% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Cyanotech's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Cyanotech actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Cyanotech's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its interest cover has the opposite effect. All these things considered, it appears that Cyanotech can comfortably handle its current debt levels. 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. Case in point: We've spotted 6 warning signs for Cyanotech you should be aware of, and 1 of them is a bit unpleasant.

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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