Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Shopify Inc. (NYSE:SHOP) makes use of debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Shopify’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Shopify had US$909.2m of debt, an increase on none, over one year. But it also has US$7.87b in cash to offset that, meaning it has US$6.96b net cash.
How Healthy Is Shopify’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Shopify had liabilities of US$495.1m due within 12 months and liabilities of US$1.19b due beyond that. Offsetting this, it had US$7.87b in cash and US$270.1m in receivables that were due within 12 months. So it actually has US$6.46b more liquid assets than total liabilities.
This surplus suggests that Shopify has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Shopify boasts net cash, so it’s fair to say it does not have a heavy debt load!
Although Shopify made a loss at the EBIT level, last year, it was also good to see that it generated US$362m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shopify can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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. Over the last year, Shopify actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company’s debt, in this case Shopify has US$6.96b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$615m, being 170% of its EBIT. So we don’t think Shopify’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.