Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Lumentum Holdings Inc. (NASDAQ:LITE) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Lumentum Holdings's Debt?
The image below, which you can click on for greater detail, shows that at December 2019 Lumentum Holdings had debt of US$1.09b, up from US$833.7m in one year. But it also has US$1.32b in cash to offset that, meaning it has US$223.6m net cash.
A Look At Lumentum Holdings's Liabilities
The latest balance sheet data shows that Lumentum Holdings had liabilities of US$304.2m due within a year, and liabilities of US$1.24b falling due after that. On the other hand, it had cash of US$1.32b and US$343.6m worth of receivables due within a year. So it actually has US$119.6m more liquid assets than total liabilities.
This state of affairs indicates that Lumentum Holdings's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$6.60b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Lumentum Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
Sadly, Lumentum Holdings's EBIT actually dropped 4.6% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Lumentum Holdings 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. During the last three years, Lumentum Holdings generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Lumentum Holdings has net cash of US$223.6m, as well as more liquid assets than liabilities. The cherry on top was that in converted 99% of that EBIT to free cash flow, bringing in US$257m. So we are not troubled with Lumentum Holdings's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Lumentum Holdings (of which 1 can't be ignored!) 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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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