Xero (ASX:XRO) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 note that Xero Limited (ASX:XRO) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Xero

What Is Xero's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Xero had debt of NZ$1.10b, up from NZ$883.0m in one year. However, its balance sheet shows it holds NZ$1.13b in cash, so it actually has NZ$24.0m net cash.

A Look At Xero's Liabilities

The latest balance sheet data shows that Xero had liabilities of NZ$237.1m due within a year, and liabilities of NZ$1.26b falling due after that. Offsetting these obligations, it had cash of NZ$1.13b as well as receivables valued at NZ$115.9m due within 12 months. So its liabilities total NZ$258.9m more than the combination of its cash and short-term receivables.

Of course, Xero has a market capitalization of NZ$12.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Xero also has more cash than debt, so we're pretty confident it can manage its debt safely.

Notably, Xero's EBIT launched higher than Elon Musk, gaining a whopping 219% on last year. 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 Xero can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Xero 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 most recent three years, Xero recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Xero has NZ$24.0m in net cash. And it impressed us with its EBIT growth of 219% over the last year. So we are not troubled with Xero's debt use. While Xero didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.