Hills Limited (ASX:HIL) is a small-cap stock with a market capitalization of AU$35m. While investors primarily focus on the growth potential and competitive landscape of the small-cap companies, they end up ignoring a key aspect, which could be the biggest threat to its existence: its financial health. Why is it important? Understanding the company's financial health becomes vital, since poor capital management may bring about bankruptcies, which occur at a higher rate for small-caps. We'll look at some basic checks that can form a snapshot the company’s financial strength. Nevertheless, these checks don't give you a full picture, so I recommend you dig deeper yourself into HIL here.
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HIL’s Debt (And Cash Flows)
HIL has built up its total debt levels in the last twelve months, from AU$24m to AU$35m , which accounts for long term debt. With this rise in debt, HIL currently has AU$13m remaining in cash and short-term investments to keep the business going. Additionally, HIL has produced cash from operations of AU$2.6m over the same time period, leading to an operating cash to total debt ratio of 7.4%, meaning that HIL’s operating cash is less than its debt.
Can HIL pay its short-term liabilities?
Looking at HIL’s AU$64m in current liabilities, it appears that the company has been able to meet these commitments with a current assets level of AU$121m, leading to a 1.9x current account ratio. The current ratio is the number you get when you divide current assets by current liabilities. Usually, for Electronic companies, this is a suitable ratio since there's a sufficient cash cushion without leaving too much capital idle or in low-earning investments.
Can HIL service its debt comfortably?
HIL is a relatively highly levered company with a debt-to-equity of 57%. This is somewhat unusual for small-caps companies, since lenders are often hesitant to provide attractive interest rates to less-established businesses. We can test if HIL’s debt levels are sustainable by measuring interest payments against earnings of a company. Ideally, earnings before interest and tax (EBIT) should cover net interest by at least three times. For HIL, the ratio of 1.23x suggests that interest is not strongly covered, which means that lenders may be more reluctant to lend out more funding as HIL’s low interest coverage already puts the company at higher risk of default.
Next Steps:
Although HIL’s debt level is towards the higher end of the spectrum, its cash flow coverage seems adequate to meet obligations which means its debt is being efficiently utilised. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. I admit this is a fairly basic analysis for HIL's financial health. Other important fundamentals need to be considered alongside. I recommend you continue to research Hills to get a more holistic view of the small-cap by looking at: