Does Tencent Holdings (HKG:700) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Tencent Holdings Limited (HKG:700) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Tencent Holdings

What Is Tencent Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Tencent Holdings had CN¥339.0b of debt, an increase on CN¥315.1b, over one year. However, it does have CN¥339.3b in cash offsetting this, leading to net cash of CN¥250.0m.

How Strong Is Tencent Holdings' Balance Sheet?

We can see from the most recent balance sheet that Tencent Holdings had liabilities of CN¥310.4b falling due within a year, and liabilities of CN¥365.4b due beyond that. On the other hand, it had cash of CN¥339.3b and CN¥45.4b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥291.1b.

Since publicly traded Tencent Holdings shares are worth a very impressive total of CN¥3.08t, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Tencent Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Tencent Holdings saw its EBIT drop by 7.0% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Tencent Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Tencent Holdings 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 three years, Tencent Holdings recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Tencent Holdings has CN¥250.0m in net cash. The cherry on top was that in converted 98% of that EBIT to free cash flow, bringing in CN¥122b. So we don't think Tencent Holdings's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Tencent Holdings , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.