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

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.' 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 note that Xiaomi Corporation (HKG:1810) does have debt on its balance sheet. 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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that 1810 is potentially undervalued!

How Much Debt Does Xiaomi Carry?

As you can see below, at the end of June 2022, Xiaomi had CN¥33.8b of debt, up from CN¥19.3b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥74.9b in cash, so it actually has CN¥41.1b net cash.

A Look At Xiaomi's Liabilities

Zooming in on the latest balance sheet data, we can see that Xiaomi had liabilities of CN¥107.3b due within 12 months and liabilities of CN¥44.9b due beyond that. Offsetting these obligations, it had cash of CN¥74.9b as well as receivables valued at CN¥40.2b due within 12 months. So it has liabilities totalling CN¥37.1b more than its cash and near-term receivables, combined.

Since publicly traded Xiaomi shares are worth a very impressive total of CN¥209.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Xiaomi boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Xiaomi's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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. During the last three years, Xiaomi produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While Xiaomi does have more liabilities than liquid assets, it also has net cash of CN¥41.1b. So we don't have any problem with Xiaomi's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Xiaomi (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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

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.