Here's Why NeoPhotonics (NYSE:NPTN) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, NeoPhotonics Corporation (NYSE:NPTN) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for NeoPhotonics

What Is NeoPhotonics's Debt?

The image below, which you can click on for greater detail, shows that NeoPhotonics had debt of US$33.4m at the end of December 2020, a reduction from US$42.0m over a year. However, its balance sheet shows it holds US$125.2m in cash, so it actually has US$91.8m net cash.

A Look At NeoPhotonics' Liabilities

According to the last reported balance sheet, NeoPhotonics had liabilities of US$88.8m due within 12 months, and liabilities of US$54.4m due beyond 12 months. Offsetting this, it had US$125.2m in cash and US$50.9m in receivables that were due within 12 months. So it actually has US$32.9m more liquid assets than total liabilities.

This short term liquidity is a sign that NeoPhotonics could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that NeoPhotonics has more cash than debt is arguably a good indication that it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, NeoPhotonics turned things around in the last 12 months, delivering and EBIT of US$6.3m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine NeoPhotonics'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that NeoPhotonics has net cash of US$91.8m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$41m, being 653% of its EBIT. So is NeoPhotonics's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for NeoPhotonics you should know about.

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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