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While small-cap stocks, such as 7Road Holdings Limited (HKG:797) with its market cap of HK$3.7b, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. Evaluating financial health as part of your investment thesis is essential, as mismanagement of capital can lead to bankruptcies, which occur at a higher rate for small-caps. Here are few basic financial health checks you should consider before taking the plunge. However, this commentary is still very high-level, so I’d encourage you to dig deeper yourself into 797 here.
How does 797’s operating cash flow stack up against its debt?
797 has shrunken its total debt levels in the last twelve months, from CN¥222m to CN¥155m – this includes long-term debt. With this debt repayment, 797’s cash and short-term investments stands at CN¥83m for investing into the business. Moreover, 797 has generated cash from operations of CN¥182m during the same period of time, resulting in an operating cash to total debt ratio of 118%, meaning that 797’s operating cash is sufficient to cover its debt. This ratio can also be interpreted as a measure of efficiency as an alternative to return on assets. In 797’s case, it is able to generate 1.18x cash from its debt capital.
Can 797 meet its short-term obligations with the cash in hand?
Looking at 797’s CN¥274m in current liabilities, it seems that the business has been able to meet these obligations given the level of current assets of CN¥520m, with a current ratio of 1.9x. For Entertainment companies, this ratio is within a sensible range as there’s enough of a cash buffer without holding too much capital in low return investments.
Is 797’s debt level acceptable?
With debt at 25% of equity, 797 may be thought of as appropriately levered. 797 is not taking on too much debt commitment, which may be constraining for future growth. We can test if 797’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 797, the ratio of 536x suggests that interest is comfortably covered, which means that lenders may be less hesitant to lend out more funding as 797’s high interest coverage is seen as responsible and safe practice.
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797 has demonstrated its ability to generate sufficient levels of cash flow, while its debt hovers at an appropriate level. In addition to this, the company will be able to pay all of its upcoming liabilities from its current short-term assets. This is only a rough assessment of financial health, and I’m sure 797 has company-specific issues impacting its capital structure decisions. I suggest you continue to research 7Road Holdings to get a more holistic view of the stock by looking at: