Here's Why Harmonic (NASDAQ:HLIT) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Harmonic Inc. (NASDAQ:HLIT) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Harmonic

What Is Harmonic's Net Debt?

As you can see below, Harmonic had US$154.6m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$133.4m in cash offsetting this, leading to net debt of about US$21.2m.

How Strong Is Harmonic's Balance Sheet?

We can see from the most recent balance sheet that Harmonic had liabilities of US$224.5m falling due within a year, and liabilities of US$173.3m due beyond that. On the other hand, it had cash of US$133.4m and US$88.5m worth of receivables due within a year. So its liabilities total US$175.8m more than the combination of its cash and short-term receivables.

Since publicly traded Harmonic shares are worth a total of US$907.1m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Given net debt is only 0.65 times EBITDA, it is initially surprising to see that Harmonic's EBIT has low interest coverage of 1.8 times. So one way or the other, it's clear the debt levels are not trivial. Importantly, Harmonic's EBIT fell a jaw-dropping 32% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Harmonic's ability to maintain a healthy balance sheet going forward. 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Harmonic recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

We weren't impressed with Harmonic's interest cover, and its EBIT growth rate made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Harmonic's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Harmonic .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.