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Is NetEase (NASDAQ:NTES) A Risky Investment?

Simply Wall St

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for NetEase

How Much Debt Does NetEase Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2019 NetEase had CN¥13.6b of debt, an increase on CN¥12.7b, over one year. But it also has CN¥55.6b in cash to offset that, meaning it has CN¥42.0b net cash.

NasdaqGS:NTES Historical Debt, September 5th 2019

How Healthy Is NetEase's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that NetEase had liabilities of CN¥33.9b due within 12 months and liabilities of CN¥1.38b due beyond that. Offsetting this, it had CN¥55.6b in cash and CN¥4.49b in receivables that were due within 12 months. So it can boast CN¥24.7b more liquid assets than total liabilities.

This surplus suggests that NetEase has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, NetEase boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, NetEase grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine NetEase's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Over the last three years, NetEase recorded free cash flow worth a fulsome 90% 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 we empathize with investors who find debt concerning, you should keep in mind that NetEase has net cash of CN¥42b, as well as more liquid assets than liabilities. The cherry on top was that in converted 90% of that EBIT to free cash flow, bringing in CN¥11b. So we don't think NetEase's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of NetEase's earnings per share history for free.

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.