David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 note that NetEase, Inc. (NASDAQ:NTES) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is NetEase’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 NetEase had debt of CN¥15.5b, up from CN¥13.6b in one year. However, its balance sheet shows it holds CN¥61.4b in cash, so it actually has CN¥45.9b net cash.
A Look At NetEase’s Liabilities
The latest balance sheet data shows that NetEase had liabilities of CN¥34.6b due within a year, and liabilities of CN¥1.21b falling due after that. Offsetting these obligations, it had cash of CN¥61.4b as well as receivables valued at CN¥4.71b due within 12 months. So it can boast CN¥30.3b more liquid assets than total liabilities.
This short term liquidity is a sign that NetEase could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, NetEase boasts net cash, so it’s fair to say it does not have a heavy debt load!
In addition to that, we’re happy to report that NetEase has boosted its EBIT by 61%, thus reducing the spectre of future debt repayments. 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 NetEase can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. NetEase may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, NetEase generated free cash flow amounting to a very robust 88% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company’s debt, in this case NetEase has CN¥45.9b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 88% of that EBIT to free cash flow, bringing in CN¥14b. So is NetEase’s debt a risk? It doesn’t seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 2 warning signs for NetEase that you should be aware of.
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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