While small-cap stocks, such as Dongguang Chemical Limited (SEHK:1702) with its market cap of HK$2.91B, 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 essential, since poor capital management may bring about bankruptcies, which occur at a higher rate for small-caps. Here are a few basic checks that are good enough to have a broad overview of the company’s financial strength. Nevertheless, given that I have not delve into the company-specifics, I recommend you dig deeper yourself into 1702 here.

Does 1702 generate an acceptable amount of cash through operations?

1702’s debt level has been constant at around CN¥915.23M over the previous year made up of current and long term debt. At this constant level of debt, 1702 currently has CN¥177.16M remaining in cash and short-term investments , ready to deploy into the business. Moving onto cash from operations, its small level of operating cash flow means calculating cash-to-debt wouldn’t be too useful, though these low levels of cash means that operational efficiency is worth a look. For this article’s sake, I won’t be looking at this today, but you can take a look at some of 1702’s operating efficiency ratios such as ROA here.

Does 1702’s liquid assets cover its short-term commitments?

Looking at 1702’s most recent CN¥940.92M liabilities, it seems that the business is not able to meet these obligations given the level of current assets of CN¥601.81M, with a current ratio of 0.64x below the prudent level of 3x.

Is 1702’s debt level acceptable?

With total debt exceeding equities, 1702 is considered a highly levered company. This is not unusual for small-caps as debt tends to be a cheaper and faster source of funding for some businesses. 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 1702’s case, the ratio of 2.41x suggests that interest is not strongly covered, which means that lenders may refuse to lend the company more money, as it is seen as too risky in terms of default.

Next Steps:

1702’s high debt level indicates room for improvement. Furthermore, its cash flow coverage of less than a quarter of debt means that operating efficiency could also be an issue. In addition to this, its lack of liquidity raises questions over current asset management practices for the small-cap. This is only a rough assessment of financial health, and I’m sure 1702 has company-specific issues impacting its capital structure decisions. I suggest you continue to research Dongguang Chemical to get a better picture of the stock by looking at: