Is Applied Optoelectronics (NASDAQ:AAOI) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Applied Optoelectronics, Inc. (NASDAQ:AAOI) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. 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.

View our latest analysis for Applied Optoelectronics

What Is Applied Optoelectronics's Debt?

As you can see below, Applied Optoelectronics had US$145.5m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$43.5m in cash, and so its net debt is US$101.9m.

How Healthy Is Applied Optoelectronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Applied Optoelectronics had liabilities of US$93.3m due within 12 months and liabilities of US$105.2m due beyond that. Offsetting this, it had US$43.5m in cash and US$52.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$102.6m.

This is a mountain of leverage relative to its market capitalization of US$119.6m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. 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 Applied Optoelectronics'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.

Over 12 months, Applied Optoelectronics made a loss at the EBIT level, and saw its revenue drop to US$209m, which is a fall of 9.3%. We would much prefer see growth.

Caveat Emptor

Over the last twelve months Applied Optoelectronics produced an earnings before interest and tax (EBIT) loss. Its EBIT loss was a whopping US$56m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled US$38m in negative free cash flow over the last twelve months. So in short it's a really risky stock. 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. For example, we've discovered 3 warning signs for Applied Optoelectronics that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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