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While small-cap stocks, such as China Electronics Optics Valley Union Holding Company Limited (HKG:798) with its market cap of HK$4.7b, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. Assessing first and foremost the financial health is crucial, as mismanagement of capital can lead to 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. However, this is just a partial view of the stock, and I recommend you dig deeper yourself into 798 here.

798’s Debt (And Cash Flows)

798's debt levels surged from CN¥4.0b to CN¥5.1b over the last 12 months – this includes long-term debt. With this growth in debt, the current cash and short-term investment levels stands at CN¥2.0b , ready to be used for running the business. Moving on, operating cash flow was negative over the last twelve months. For this article’s sake, I won’t be looking at this today, but you can assess some of 798’s operating efficiency ratios such as ROA here.

Does 798’s liquid assets cover its short-term commitments?

With current liabilities at CN¥6.0b, it seems that the business has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 1.65x. The current ratio is calculated by dividing current assets by current liabilities. For Real Estate companies, this ratio is within a sensible range since there is a bit of a cash buffer without leaving too much capital in a low-return environment.

Is 798’s debt level acceptable?

798 is a relatively highly levered company with a debt-to-equity of 74%. This is a bit unusual for a small-cap stock, since they generally have a harder time borrowing than large more established companies. We can test if 798’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 798, the ratio of 6.17x suggests that interest is appropriately covered, which means that lenders may be willing to lend out more funding as 798’s high interest coverage is seen as responsible and safe practice.

Next Steps:

Although 798’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. Since there is also no concerns around 798's liquidity needs, this may be its optimal capital structure for the time being. Keep in mind I haven't considered other factors such as how 798 has been performing in the past. I recommend you continue to research China Electronics Optics Valley Union Holding to get a more holistic view of the small-cap by looking at: