In This Article:
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Reece Limited (ASX:REH) is a small-cap stock with a market capitalization of AU$5.8b. While investors primarily focus on the growth potential and competitive landscape of the small-cap companies, they end up ignoring a key aspect, which could be the biggest threat to its existence: its financial health. Why is it important? Assessing first and foremost the financial health is essential, 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. Nevertheless, this is not a comprehensive overview, so I recommend you dig deeper yourself into REH here.
REH’s Debt (And Cash Flows)
REH's debt levels surged from AU$100m to AU$1.7b over the last 12 months – this includes long-term debt. With this rise in debt, REH currently has AU$99m remaining in cash and short-term investments to keep the business going. Additionally, REH has generated AU$139m in operating cash flow in the last twelve months, resulting in an operating cash to total debt ratio of 8.2%, meaning that REH’s operating cash is less than its debt.
Can REH meet its short-term obligations with the cash in hand?
Looking at REH’s AU$807m in current liabilities, the company has been able to meet these obligations given the level of current assets of AU$1.9b, with a current ratio of 2.31x. The current ratio is the number you get when you divide current assets by current liabilities. For Trade Distributors companies, this ratio is within a sensible range since there's a sufficient cash cushion without leaving too much capital idle or in low-earning investments.
Can REH service its debt comfortably?
With debt reaching 86% of equity, REH may be thought of as relatively highly levered. 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 REH’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 REH, the ratio of 8.86x suggests that interest is appropriately covered, which means that lenders may be willing to lend out more funding as REH’s high interest coverage is seen as responsible and safe practice.
Next Steps:
REH’s high cash coverage means that, although its debt levels are high, the company is able to utilise its borrowings efficiently in order to generate cash flow. Since there is also no concerns around REH'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 REH has been performing in the past. I suggest you continue to research Reece to get a better picture of the small-cap by looking at: