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

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Applied Optoelectronics, Inc. (NASDAQ:AAOI) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Applied Optoelectronics

What Is Applied Optoelectronics's Debt?

The image below, which you can click on for greater detail, shows that Applied Optoelectronics had debt of US$125.8m at the end of June 2023, a reduction from US$142.9m over a year. However, because it has a cash reserve of US$21.6m, its net debt is less, at about US$104.3m.

How Strong Is Applied Optoelectronics' Balance Sheet?

According to the last reported balance sheet, Applied Optoelectronics had liabilities of US$187.5m due within 12 months, and liabilities of US$6.15m due beyond 12 months. On the other hand, it had cash of US$21.6m and US$43.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$128.7m.

Applied Optoelectronics has a market capitalization of US$353.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Applied Optoelectronics 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.

Over 12 months, Applied Optoelectronics saw its revenue hold pretty steady, and it did not report positive earnings before interest and tax. While that's not too bad, we'd prefer see growth.

Caveat Emptor

Over the last twelve months Applied Optoelectronics produced an earnings before interest and tax (EBIT) loss. Indeed, it lost a very considerable US$62m at the EBIT level. 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. However, it doesn't help that it burned through US$11m of cash over the last year. So to be blunt we think it 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Applied Optoelectronics (of which 1 is a bit unpleasant!) you should know about.

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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