While small-cap stocks, such as Afterpay Touch Group Limited (ASX:APT) with its market cap of AUD A$1.12B, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. There are always disruptions which destabilize an existing industry, in which most small-cap companies are the first casualties. These factors make a basic understanding of a company’s financial position of utmost importance for a potential investor. Here are a few basic checks that are good enough to have a broad overview of the company’s financial strength. View our latest analysis for Afterpay Touch Group

Does APT generate an acceptable amount of cash through operations?

While failure to manage cash has been one of the major reasons behind the demise of a lot of small businesses, mismanagement comes into the light during tough situations such as an economic recession. These adverse events bring devastation and yet does not absolve the company from its debt. We can test the impact of these adverse events by looking at whether cash from its current operations can pay back its current debt obligations. Last year, APT’s operating cash flow was -1.69x its current debt. This means what APT can generate on an annual basis, which is currently a negative value, does not cover what it actually owes its debtors in the near term. This raises a red flag, looking at APT’s operations at this point in time.

Does APT’s liquid assets cover its short-term commitments?

In addition to debtholders, a company must be able to pay its bills and salaries to keep the business running. In times of adverse events, APT may need to liquidate its short-term assets to pay these immediate obligations. We test for APT’s ability to meet these needs by comparing its cash and short-term investments with current liabilities. Our analysis shows that APT does have enough liquid assets on hand to meet its upcoming liabilities, which lowers our concerns should adverse events arise.

Does APT face the risk of succumbing to its debt-load?

A substantially higher debt poses a significant threat to a company’s profitability during a downturn. In the case of APT, the debt-to-equity ratio is 29.20%, which indicates that its debt is at an acceptable level. No matter how high the company’s debt, if it can easily cover the interest payments, it’s considered to be efficient with its use of excess leverage. A company generating earnings at least three times its interest payments is considered financially sound. In APT’s case, its interest is not sufficiently covered by its profits as the ratio is 2.7x. Debtors may be less inclined to loan the company more money, giving APT less headroom for growth through debt.

Next Steps:

Are you a shareholder? Although APT’s debt level is relatively low, its cash flow levels still could not copiously cover its borrowings. This may indicate room for improvement in terms of its operating efficiency. Though, the company will be able to pay all of its upcoming liabilities from its current short-term assets. Given that its financial position may change. I suggest keeping on top of market expectations for APT’s future growth on our free analysis platform.

Are you a potential investor? APT’s low-debt position gives it headroom for future growth funding in the future. Moreover, its high liquidity means the company should continue to operate smoothly in the case of adverse events. In order to build your conviction in the stock, you need to also examine APT’s track record. I encourage you to continue your research by taking a look at APT’s past performance analysis on our free platform to conclude on APT’s financial health.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.