Xero is Cool New Accounting Software: So How Are They Doing Financially?

Xero is making a big splash in the U.S. with their cloud-based accounting software for small businesses. The company is fascinating to me on a number of fronts:

• Their tag line is "Beautiful Accounting Software". Not too often do you here accounting software referred to as "beautiful". It begs the question: Is it really beautiful? Do business owners love it? Do accountants and CPAs love it… and do they use it? I can't wait to see how it all plays out.
• They seem to have awakened Intuit to move faster to improve QuickBooks Online. The vast majority of small businesses use QuickBooks desktop. And most of them hate the idea of moving from QuickBooks desktop to QuickBooks Online. Intuit is starting to move much faster to make their online version better… at least partly as a result of Xero breaking into the market for cloud-based accounting.
• Xero is raising tons of cash… and spending it incredibly fast. Not only are their losses growing, the losses are growing at an accelerating rate.

Being a longtime CFO, it's the "losing a bunch of money" point that fascinates me the most. So let's dive into their most recent financials and sees what Xero looks like financially.

The Cash Flow Focus Report

Regular readers of this blog know that my focus always starts with "What's going on with the cash?" I teach business owners that just 10 minutes a month is all it takes to understand what's going on with their cash flow. If they can't sit down with their banker or their business partner and explain what happened to the cash last month (in a 2-minute conversation) then they don't really know what's going on financially.

I use the same approach when I look at a much larger company and want to understand what makes them tick financially. It all starts with completing what I call the Cash Flow Focus Report. (It should only take 10 minutes to complete the report.) Here is the 3-step process:

• Focus on the three largest drivers of cash
• Write a one line explanation of each cash driver
• Label each change as good or bad

Xero Meets the Cash Flow Focus Report

For the six months ended September 30, 2013, Xero lost $17 million and their cash went down by $23 million. So the all-important cash flow question is: "What happened to the cash."

Xero is a publicly traded company (XRO) on the New Zealand Stock Exchange and the Australian Securities Exchange. So their financial information is easy to get. I pulled the financials for the six months ended September 30, 2013.

Here's the Cash Flow Focus Report for that six month period (all amounts are shown in millions – that's part of the keep-it-simple approach to understanding cash flow):

(Click here to see a larger view of the Cash Flow Focus Report)

(Click here to see a larger view of the Cash Flow Focus Report)

The Three Largest Drivers of Cash Flow

I have found that the essence of simplifying cash flow for any company (small or large) is to focus on understanding the three largest drivers of cash for the period. It is an amazingly effective way to understand the cash flow of any company. (And it's designed to pretty much fit on a note card.)

Let's look at each of the three big drivers of Xero's cash flow for the six months.

• Net loss – The company lost $17 million on $30 million in revenues. That's a big percentage of revenues. In deciding to label this either good or bad, I would normally look at the budget or the projections to see if it is line with expectations and strategy. In this case, I labeled it as good because it appears on the surface to be a part of Xero's growth strategy. The Chairman and Chief Executive Commentary in the report said "The company expects to exceed 80% growth in operating revenue for the full year to March 31, 2014 and continue to incur increased operating losses for the second 6 month period as it continues to invest". They go on to say "the Board is continuing to follow a growth agenda focused on creating longer-term shareholder value rather than short-term profitability". For better or for worse, losing money right now is part of their strategic plan.
• Capitalized development costs – A good portion of the money Xero is spending is to create the cloud-based software they are selling (and plan to sell in the future). Hard to tell how much of it is being expensed as incurred. But no doubt a lot of money is being spent on developing the software and a good portion of it is being put on the balance sheet to be amortized (expensed) over time. I labeled it as good since it appears to fit their overall strategy.
• Amortization – $3 million of those capitalized development costs were amortized (expensed) over the six month period. There is still $25 million of unamortized costs on the balance sheet at September 30, 2013 remaining to be expensed in the coming months and years. I labeled it as good since the costs have to be amortized.

Now the Next Question: What's About to Happen to the Cash?

Now we have answered the first key question: "What happened to the cash"? The next question is "What's about to happen to the cash"? Those are the two questions you need to be able to answer in your business at the end of every month.

A quick look at how Xero has been funding their net losses and software development costs gives some insight into the future of their cash flow.

In short, they have been raising capital… lots of capital.

They have raised over $250 million in the last two years or so.

In October 2013, they raised $180 million in cash. Here is how they described it:

"Xero's capital raise in October 2013 from sophisticated technology investors has removed substantial risk from the business. It is a clear signal that the company is operating on a world-class basis and ensures the company is in a strong position to continue its growth agenda".

Future Cash Flow

We can make a few estimates/assumptions about future cash flow based on what we see in the Cash Flow Focus Report and the October capital infusion:

1. They said in the report they would continue losing money… and they would do it at an increasing rate.
2. They will surely continue the software development costs. There's no business without the software.
3. They had $55 million of cash at September 30, 2013 and they raised an additional $180 million in October. That's a pretty hefty war chest that should last them a little while!

We'll see what happens when they provide their annual report for the year ended March 31, 2014. I'll update the Cash Flow Focus report and share it with you.

And there's more that makes Xero such a fascinating company and software. I'll share those with you in my next post.

You can learn more about my online course Understanding Your Cash Flow – In Less Than 10 Minutes by clicking here. The course is very short and focused on helping you better understand your cash flow and put the Cash Flow Focus Report to work in your business.

It's all about simplifying cash flow.

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