While small-cap stocks, such as China XLX Fertiliser Ltd (SEHK:1866) with its market cap of HK$3.53B, 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 vital, 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, since I only look at basic financial figures, I suggest you dig deeper yourself into 1866 here.

Does 1866 generate an acceptable amount of cash through operations?

Over the past year, 1866 has maintained its debt levels at around CN¥5.26B made up of current and long term debt. At this current level of debt, 1866’s cash and short-term investments stands at CN¥516.99M for investing into the business. Additionally, 1866 has generated cash from operations of CN¥364.82M over the same time period, leading to an operating cash to total debt ratio of 6.94%, indicating that 1866’s debt is not appropriately covered by operating cash. This ratio can also be a sign of operational efficiency as an alternative to return on assets. In 1866’s case, it is able to generate 0.069x cash from its debt capital.

Can 1866 pay its short-term liabilities?

At the current liabilities level of CN¥3.03B liabilities, it seems that the business has not maintained a sufficient level of current assets to meet its obligations, with the current ratio last standing at 0.68x, which is below the prudent industry ratio of 3x.

Can 1866 service its debt comfortably?

Since total debt levels have outpaced equities, 1866 is a highly leveraged company. This is not uncommon for a small-cap company given that debt tends to be lower-cost and at times, more accessible. 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 after interest and tax at least three times its net interest payments is considered financially sound. In 1866’s case, the ratio of 1.62x suggests that interest is not strongly covered, which means that lenders may be more reluctant to lend out more funding as 1866’s low interest coverage already puts the company at higher risk of default.

Next Steps:

1866’s high debt levels is not met with high cash flow coverage. This leaves room for improvement in terms of debt management and operational efficiency. In addition to this, its low liquidity raises concerns over whether current asset management practices are properly implemented for the small-cap. I admit this is a fairly basic analysis for 1866’s financial health. Other important fundamentals need to be considered alongside. You should continue to research China XLX Fertiliser to get a more holistic view of the stock by looking at: