XP Power (LON:XPP) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies XP Power Limited (LON:XPP) makes use of debt. But should shareholders be worried about its use of debt?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for XP Power

How Much Debt Does XP Power Carry?

The image below, which you can click on for greater detail, shows that at December 2021 XP Power had debt of UK£33.6m, up from UK£31.8m in one year. However, because it has a cash reserve of UK£9.30m, its net debt is less, at about UK£24.3m.

How Healthy Is XP Power's Balance Sheet?

According to the last reported balance sheet, XP Power had liabilities of UK£49.0m due within 12 months, and liabilities of UK£50.8m due beyond 12 months. Offsetting these obligations, it had cash of UK£9.30m as well as receivables valued at UK£34.9m due within 12 months. So its liabilities total UK£55.6m more than the combination of its cash and short-term receivables.

Given XP Power has a market capitalization of UK£649.5m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

XP Power's net debt is only 0.67 times its EBITDA. And its EBIT covers its interest expense a whopping 24.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, XP Power's EBIT dived 19%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if XP Power can strengthen its balance sheet over time. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, XP Power generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

XP Power's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its EBIT growth rate has the opposite effect. All these things considered, it appears that XP Power can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for XP Power 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.