Here's Why Xiaomi (HKG:1810) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Xiaomi Corporation (HKG:1810) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Xiaomi

What Is Xiaomi's Net Debt?

The image below, which you can click on for greater detail, shows that Xiaomi had debt of CN¥13.8b at the end of June 2019, a reduction from CN¥163.1b over a year. But on the other hand it also has CN¥50.5b in cash, leading to a CN¥36.7b net cash position.

How Healthy Is Xiaomi's Balance Sheet?

The latest balance sheet data shows that Xiaomi had liabilities of CN¥69.2b due within a year, and liabilities of CN¥12.2b falling due after that. Offsetting this, it had CN¥50.5b in cash and CN¥35.8b in receivables that were due within 12 months. So it actually has CN¥4.84b more liquid assets than total liabilities.

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

Also positive, Xiaomi grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Xiaomi's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Xiaomi 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. In the last three years, Xiaomi created free cash flow amounting to 4.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Xiaomi has CN¥36.7b in net cash and a decent-looking balance sheet. And we liked the look of last year's 25% year-on-year EBIT growth. So we don't have any problem with Xiaomi's use of debt. We'd be motivated to research the stock further if we found out that Xiaomi insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.