Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Lumentum Holdings Inc. (NASDAQ:LITE) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Lumentum Holdings's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Lumentum Holdings had debt of US$1.15b, up from US$1.09b in one year. However, it does have US$1.70b in cash offsetting this, leading to net cash of US$550.9m.
A Look At Lumentum Holdings' Liabilities
We can see from the most recent balance sheet that Lumentum Holdings had liabilities of US$647.3m falling due within a year, and liabilities of US$899.0m due beyond that. Offsetting this, it had US$1.70b in cash and US$281.9m in receivables that were due within 12 months. So it actually has US$435.9m more liquid assets than total liabilities.
This surplus suggests that Lumentum Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Lumentum Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Lumentum Holdings has boosted its EBIT by 88%, thus reducing the spectre of future debt repayments. 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 Lumentum Holdings'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. While Lumentum Holdings 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 three years, Lumentum Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While we empathize with investors who find debt concerning, you should keep in mind that Lumentum Holdings has net cash of US$550.9m, as well as more liquid assets than liabilities. The cherry on top was that in converted 128% of that EBIT to free cash flow, bringing in US$408m. So is Lumentum Holdings'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. For instance, we've identified 1 warning sign for Lumentum Holdings that you should be aware of.
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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