Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Tencent Holdings Limited (HKG:700) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Tencent Holdings

What Is Tencent Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2019 Tencent Holdings had debt of CN¥200.2b, up from CN¥169.5b in one year. However, it also had CN¥184.5b in cash, and so its net debt is CN¥15.7b.

How Healthy Is Tencent Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tencent Holdings had liabilities of CN¥201.9b due within 12 months and liabilities of CN¥193.9b due beyond that. Offsetting this, it had CN¥184.5b in cash and CN¥35.7b in receivables that were due within 12 months. So its liabilities total CN¥175.6b more than the combination of its cash and short-term receivables.

Of course, Tencent Holdings has a titanic market capitalization of CN¥2.96t, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Tencent Holdings has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Tencent Holdings has net debt of just 0.13 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. The good news is that Tencent Holdings has increased its EBIT by 8.6% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Tencent Holdings's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Tencent Holdings generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Tencent Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Tencent Holdings's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. We'd be very excited to see if Tencent Holdings insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.