Xref (ASX:XF1) Seems To Use Debt Rather Sparingly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Xref Limited (ASX:XF1) makes use of debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Xref

How Much Debt Does Xref Carry?

As you can see below, Xref had AU$4.56m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has AU$10.4m in cash, leading to a AU$5.89m net cash position.

A Look At Xref's Liabilities

The latest balance sheet data shows that Xref had liabilities of AU$12.6m due within a year, and liabilities of AU$4.32m falling due after that. Offsetting these obligations, it had cash of AU$10.4m as well as receivables valued at AU$2.55m due within 12 months. So its liabilities total AU$3.96m more than the combination of its cash and short-term receivables.

Of course, Xref has a market capitalization of AU$78.8m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Xref boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, Xref turned things around in the last 12 months, delivering and EBIT of AU$2.0m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Xref will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Xref 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. Over the last year, Xref 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.

Summing up

We could understand if investors are concerned about Xref's liabilities, but we can be reassured by the fact it has has net cash of AU$5.89m. And it impressed us with free cash flow of AU$3.5m, being 173% of its EBIT. So we don't think Xref's use of debt is risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Xref you should know about.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.