NeoPhotonics (NYSE:NPTN) Seems To Use Debt Rather Sparingly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that NeoPhotonics Corporation (NYSE:NPTN) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for NeoPhotonics

What Is NeoPhotonics's Net Debt?

The image below, which you can click on for greater detail, shows that NeoPhotonics had debt of US$34.7m at the end of September 2020, a reduction from US$47.5m over a year. However, it does have US$114.0m in cash offsetting this, leading to net cash of US$79.3m.

A Look At NeoPhotonics's Liabilities

Zooming in on the latest balance sheet data, we can see that NeoPhotonics had liabilities of US$109.0m due within 12 months and liabilities of US$55.7m due beyond that. Offsetting these obligations, it had cash of US$114.0m as well as receivables valued at US$67.1m due within 12 months. So it actually has US$16.4m 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$16m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if NeoPhotonics can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. NeoPhotonics 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. Happily for any shareholders, NeoPhotonics actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that NeoPhotonics has net cash of US$79.3m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$53m, being 331% of its EBIT. So is NeoPhotonics's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with NeoPhotonics (including 1 which is is concerning) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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