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. Importantly, AXT, Inc. (NASDAQ:AXTI) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does AXT Carry?

The image below, which you can click on for greater detail, shows that at March 2021 AXT had debt of US$10.4m, up from US$6.07m in one year. But it also has US$61.4m in cash to offset that, meaning it has US$51.1m net cash.

How Strong Is AXT’s Balance Sheet?

The latest balance sheet data shows that AXT had liabilities of US$39.5m due within a year, and liabilities of US$3.76m falling due after that. On the other hand, it had cash of US$61.4m and US$28.4m worth of receivables due within a year. So it can boast US$46.6m more liquid assets than total liabilities.

This short term liquidity is a sign that AXT could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that AXT has more cash than debt is arguably a good indication that it can manage its debt safely.

Although AXT made a loss at the EBIT level, last year, it was also good to see that it generated US$8.1m in EBIT over the last twelve months. 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 AXT’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While AXT 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 year, AXT saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

While it is always sensible to investigate a company’s debt, in this case AXT has US$51.1m in net cash and a decent-looking balance sheet. So we are not troubled with AXT’s debt use. 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.