While small-cap stocks, such as Village Roadshow Limited (ASX:VRL) with its market cap of AUD A$615.03M, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. Why is it important? A major downturn in the energy industry has resulted in over 150 companies going bankrupt and has put more than 100 on the verge of a collapse, primarily due to excessive debt. Here are few basic financial health checks to judge whether a company fits the bill or there is an additional risk which you should consider before taking the plunge. See our latest analysis for VRL

Does VRL generate enough cash through operations?

Unxpected adverse events, such as natural disasters and wars, can be a true test of a company’s capacity to meet its obligations. These adverse events bring devastation and yet does not absolve the company from its debt. 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. Last year, VRL’s operating cash flow was 0.21x its current debt. A ratio of over 0.1x shows that VRL is generating adequate cash from its core business, which should increase its potential to pay back near-term debt.

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

What about its commitments to other stakeholders such as payments to suppliers and employees? During times of unfavourable events, VRL could be required to liquidate some of its assets to meet these upcoming payments, as cash flow from operations is hindered. We test for VRL’s ability to meet these needs by comparing its cash and short-term investments with current liabilities. Our analysis shows that VRL does have enough liquid assets on hand to meet its upcoming liabilities, which lowers our concerns should adverse events arise.

Can VRL service its debt comfortably?

Debt-to-equity ratio tells us how much of the asset debtors could claim if the company went out of business. VRL’s debt-to-equity ratio exceeds 100%, which means that it is a highly leveraged company. This is not a problem if the company has consistently grown its profits. But during a business downturn, as liquidity may dry up, making it hard to operate. While debt-to-equity ratio has several factors at play, an easier way to check whether VRL’s leverage is at a sustainable level is to check its ability to service the debt. A company generating earnings at least three times its interest payments is considered financially sound. VRL’s interest on debt is not strongly covered by earnings as it sits at around 1.75x. Debtors may be less inclined to loan the company more money, giving VRL less headroom for growth through debt.