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. As with many other companies XPO, Inc. (NYSE:XPO) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is XPO's Debt?

As you can see below, at the end of June 2024, XPO had US$3.17b of debt, up from US$2.31b a year ago. Click the image for more detail. However, because it has a cash reserve of US$251.0m, its net debt is less, at about US$2.92b.

How Strong Is XPO's Balance Sheet?

According to the last reported balance sheet, XPO had liabilities of US$1.54b due within 12 months, and liabilities of US$4.69b due beyond 12 months. On the other hand, it had cash of US$251.0m and US$1.09b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.89b.

While this might seem like a lot, it is not so bad since XPO has a huge market capitalization of US$12.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

XPO's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that XPO's EBIT shot up like bamboo after rain, gaining 32% in the last twelve months. That'll make it easier to manage its debt. 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 XPO'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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, XPO saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither XPO's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that XPO's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for XPO you should be aware of, and 1 of them makes us a bit uncomfortable.

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.