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 Harmonic Inc. (NASDAQ:HLIT) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Harmonic Carry?
The chart below, which you can click on for greater detail, shows that Harmonic had US$153.8m in debt in October 2021; about the same as the year before. However, because it has a cash reserve of US$128.4m, its net debt is less, at about US$25.4m.
How Strong Is Harmonic’s Balance Sheet?
According to the last reported balance sheet, Harmonic had liabilities of US$203.7m due within 12 months, and liabilities of US$166.4m due beyond 12 months. Offsetting these obligations, it had cash of US$128.4m as well as receivables valued at US$87.1m due within 12 months. So its liabilities total US$154.6m more than the combination of its cash and short-term receivables.
Since publicly traded Harmonic shares are worth a total of US$1.16b, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 0.34 and interest cover of 5.6 times, it seems to us that Harmonic is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Harmonic improved its EBIT from a last year’s loss to a positive US$60m. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Harmonic can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Harmonic generated free cash flow amounting to a very robust 98% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Harmonic’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. Taking all this data into account, it seems to us that Harmonic takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There’s no doubt that we learn most about debt from the balance sheet.