Investors are always looking for growth in small-cap stocks like Etherstack plc (ASX:ESK), with a market cap of AUD A$20.10M. However, an important fact which most ignore is: how financially healthy is the company? The significance of doing due diligence on a company’s financial strength stems from the fact that over 20,000 companies go bankrupt in every quarter in the US alone. Thus, it becomes utmost important for an investor to test a company’s resilience for such contingencies. In simple terms, I believe these three small calculations tell most of the story you need to know. Check out our latest analysis for Etherstack

How does ESK’s operating cash flow stack up against its debt?

There are many headwinds that come unannounced, such as natural disasters and political turmoil, which can challenge a small business and its ability to adapt and recover. Furthermore, failure to service debt can hurt its reputation, making funding expensive in the future. Fortunately, we can test the company’s capacity to pay back its debtholders without summoning any catastrophes by looking at how much cash it generates from its current operations. In the case of ESK, operating cash flow turned out to be -0.32x its debt level over the past twelve months. This means what ESK 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 ESK’s operations at this point in time.

Does ESK’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. During times of unfavourable events, ESK could be required to liquidate some of its assets to meet these upcoming payments, as cash flow from operations is hindered. We should examine if the company’s cash and short-term investment levels match its current liabilities. Our analysis shows that ESK is unable to meet all of its upcoming commitments with its cash and other short-term assets. While this is not abnormal for companies, as their cash is better invested in the business or returned to investors than lying around, it does bring about some concerns should any unfavourable circumstances arise.

Is ESK’s level of debt at an acceptable level?

While ideally the debt-to equity ratio of a financially healthy company should be less than 40%, several factors such as industry life-cycle and economic conditions can result in a company raising a significant amount of debt. In the case of ESK, the debt-to-equity ratio is 87.68%, which indicates that its debt can cause trouble for the company in a downturn but it is still at a manageable level. We can test if ESK’s debt levels are sustainable by measuring interest payments against earnings of a company. Ideally, earnings should cover interest by at least three times, therefore reducing concerns when profit is highly volatile. ESK’s profits amply covers interest at 47.18 times, which is seen as relatively safe. Lenders may be less hesitant to lend out more funding as ESK’s high interest coverage is seen as responsible and safe practice.

Next Steps:

Are you a shareholder? ESK’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, the company may not be able to pay all of its upcoming liabilities from its current short-term assets. In the future, ESK’s financial situation may change. I recommend keeping abreast of market expectations for ESK’s future growth on our free analysis platform.

Are you a potential investor? ESK’s high debt levels on top of low cash coverage of debt in addition to low liquidity coverage of short-term commitments may scare some investors away intially. But, keep in mind that this is a point-in-time analysis, and today’s performance may not be representative of ESK’s track record. I encourage you to continue your research by taking a look at ESK’s past performance analysis on our free platform in order to determine for yourself whether its debt position is justified.

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.