Is Shopify (NYSE:SHOP) Using Too Much Debt?

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. We can see that Shopify Inc. (NYSE:SHOP) does use debt in its business. 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shopify

What Is Shopify's Debt?

The chart below, which you can click on for greater detail, shows that Shopify had US$911.5m in debt in March 2022; about the same as the year before. However, its balance sheet shows it holds US$7.25b in cash, so it actually has US$6.34b net cash.

A Look At Shopify's Liabilities

We can see from the most recent balance sheet that Shopify had liabilities of US$681.9m falling due within a year, and liabilities of US$1.36b due beyond that. Offsetting this, it had US$7.25b in cash and US$324.5m in receivables that were due within 12 months. So it actually has US$5.53b more liquid assets than total liabilities.

This short term liquidity is a sign that Shopify could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Shopify boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Shopify if management cannot prevent a repeat of the 70% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shopify'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shopify 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. Happily for any shareholders, Shopify actually produced more free cash flow than EBIT over the last two years. 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 Shopify has net cash of US$6.34b, as well as more liquid assets than liabilities. The cherry on top was that in converted 216% of that EBIT to free cash flow, bringing in US$254m. So we don't have any problem with Shopify's use of debt. 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 Shopify you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.