Tencent Holdings (HKG:700) Seems To Use Debt Rather Sparingly

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. As with many other companies Tencent Holdings Limited (HKG:700) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Tencent Holdings

How Much Debt Does Tencent Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Tencent Holdings had CN¥259.5b of debt, an increase on CN¥207.3b, over one year. However, because it has a cash reserve of CN¥236.0b, its net debt is less, at about CN¥23.6b.

A Look At Tencent Holdings's Liabilities

We can see from the most recent balance sheet that Tencent Holdings had liabilities of CN¥259.3b falling due within a year, and liabilities of CN¥284.2b due beyond that. On the other hand, it had cash of CN¥236.0b and CN¥41.7b worth of receivables due within a year. So its liabilities total CN¥265.9b more than the combination of its cash and short-term receivables.

Since publicly traded Tencent Holdings shares are worth a very impressive total of CN¥4.73t, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Tencent Holdings has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Tencent Holdings's net debt is only 0.14 times its EBITDA. And its EBIT covers its interest expense a whopping 201 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Tencent Holdings grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Tencent Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Tencent Holdings's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. It looks Tencent Holdings has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. 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. Case in point: We've spotted 2 warning signs for Tencent Holdings you should be aware of.

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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