Is Rare Earth Magnesium Technology Group Holdings Limited's (HKG:601) Balance Sheet A Threat To Its Future?

Simply Wall St

Tue, May 28, 2019, 8:48 PM

While small-cap stocks, such as Rare Earth Magnesium Technology Group Holdings Limited (HKG:601) with its market cap of HK$1.7b, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. 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. The following basic checks can help you get a picture of the company's balance sheet strength. However, this is just a partial view of the stock, and I’d encourage you to dig deeper yourself into 601 here.

Does 601 Produce Much Cash Relative To Its Debt?

Over the past year, 601 has reduced its debt from HK$1.1b to HK$910m , which includes long-term debt. With this debt repayment, 601 currently has HK$132m remaining in cash and short-term investments to keep the business going. On top of this, 601 has produced cash from operations of HK$319m during the same period of time, leading to an operating cash to total debt ratio of 35%, indicating that 601’s debt is appropriately covered by operating cash.

Can 601 pay its short-term liabilities?

With current liabilities at HK$172m, it appears that the company has been able to meet these obligations given the level of current assets of HK$689m, with a current ratio of 4x. The current ratio is calculated by dividing current assets by current liabilities. However, a ratio above 3x may be considered excessive by some investors, yet this is not usually a major negative for a company.

Can 601 service its debt comfortably?

With debt reaching 72% of equity, 601 may be thought of as relatively highly levered. This is somewhat unusual for small-caps companies, since lenders are often hesitant to provide attractive interest rates to less-established businesses. We can check to see whether 601 is able to meet its debt obligations by looking at the net interest coverage ratio. A company generating earnings before interest and tax (EBIT) at least three times its net interest payments is considered financially sound. In 601's, case, the ratio of 4.67x suggests that interest is appropriately covered, which means that lenders may be inclined to lend more money to the company, as it is seen as safe in terms of payback.

Next Steps:

Although 601’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 601's liquidity needs, this may be its optimal capital structure for the time being. This is only a rough assessment of financial health, and I'm sure 601 has company-specific issues impacting its capital structure decisions. I suggest you continue to research Rare Earth Magnesium Technology Group Holdings to get a better picture of the small-cap by looking at: