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. 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 Xiaomi Corporation (HKG:1810) makes use of debt. But is this debt a concern to shareholders?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Xiaomi Carry?
The image below, which you can click on for greater detail, shows that at September 2019 Xiaomi had debt of CN¥15.5b, up from CN¥9.9k in one year. However, it does have CN¥54.6b in cash offsetting this, leading to net cash of CN¥39.0b.
How Strong Is Xiaomi's Balance Sheet?
We can see from the most recent balance sheet that Xiaomi had liabilities of CN¥77.8b falling due within a year, and liabilities of CN¥10.3b due beyond that. Offsetting this, it had CN¥54.6b in cash and CN¥22.1b in receivables that were due within 12 months. So its liabilities total CN¥11.5b more than the combination of its cash and short-term receivables.
Given Xiaomi has a humongous market capitalization of CN¥296.4b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Xiaomi boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, Xiaomi grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Xiaomi 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. In the last three years, Xiaomi created free cash flow amounting to 12% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
We could understand if investors are concerned about Xiaomi's liabilities, but we can be reassured by the fact it has has net cash of CN¥39.0b. And we liked the look of last year's 47% year-on-year EBIT growth. So is Xiaomi's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Xiaomi (at least 1 which is potentially serious) , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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