Xero (ASX:XRO) Could Easily Take On More Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Xero Limited (ASX:XRO) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Xero

What Is Xero's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Xero had debt of NZ$1.11b, up from NZ$1.02b in one year. However, its balance sheet shows it holds NZ$1.53b in cash, so it actually has NZ$422.1m net cash.

A Look At Xero's Liabilities

According to the last reported balance sheet, Xero had liabilities of NZ$264.1m due within 12 months, and liabilities of NZ$1.29b due beyond 12 months. Offsetting this, it had NZ$1.53b in cash and NZ$117.6m in receivables that were due within 12 months. So it can boast NZ$89.0m more liquid assets than total liabilities.

This state of affairs indicates that Xero'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 NZ$22.0b company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Xero boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Xero grew its EBIT by 181% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Xero'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. Xero 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 three years, Xero actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Xero has net cash of NZ$422.1m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NZ$343m, being 115% of its EBIT. So we don't think Xero's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Xero's earnings per share history 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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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com