ERG S.p.A. (BIT:ERG) is a small-cap stock with a market capitalization of €2.4b. 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? Understanding the company's financial health becomes 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. However, this is just a partial view of the stock, and I’d encourage you to dig deeper yourself into ERG here.

ERG’s Debt (And Cash Flows)

Over the past year, ERG has ramped up its debt from €2.1b to €2.2b , which includes long-term debt. With this increase in debt, the current cash and short-term investment levels stands at €774m to keep the business going. Moreover, ERG has produced cash from operations of €297m in the last twelve months, leading to an operating cash to total debt ratio of 13%, indicating that ERG’s current level of operating cash is not high enough to cover debt.

Can ERG pay its short-term liabilities?

At the current liabilities level of €528m, it seems that the business has been able to meet these commitments with a current assets level of €1.2b, leading to a 2.31x current account ratio. The current ratio is the number you get when you divide current assets by current liabilities. For Renewable Energy 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 ERG service its debt comfortably?

Since total debt levels exceed equity, ERG is a highly leveraged company. 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 ERG 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 ERG's, case, the ratio of 7.34x 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:

ERG’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 ERG'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 ERG has company-specific issues impacting its capital structure decisions. You should continue to research ERG to get a better picture of the small-cap by looking at:

1. Future Outlook: What are well-informed industry analysts predicting for ERG’s future growth? Take a look at our free research report of analyst consensus for ERG’s outlook.

2. Valuation: What is ERG worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether ERG is currently mispriced by the market.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.