Australian Pharmaceutical Industries Limited (ASX:API) is a small-cap stock with a market capitalization of AU$749m. 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? Evaluating financial health as part of your investment thesis is crucial, since poor capital management may bring about 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, potential investors would need to take a closer look, and I suggest you dig deeper yourself into API here.

API’s Debt (And Cash Flows)

API's debt levels surged from AU$52m to AU$277m over the last 12 months – this includes long-term debt. With this growth in debt, API currently has AU$15m remaining in cash and short-term investments to keep the business going. Its negative operating cash flow means calculating cash-to-debt wouldn't be useful. As the purpose of this article is a high-level overview, I won’t be looking at this today, but you can assess some of API’s operating efficiency ratios such as ROA here.

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

At the current liabilities level of AU$734m, the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 1.41x. The current ratio is the number you get when you divide current assets by current liabilities. Usually, for Healthcare companies, this is a suitable ratio since there is a bit of a cash buffer without leaving too much capital in a low-return environment.

Does API face the risk of succumbing to its debt-load?

With debt reaching 54% of equity, API 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. No matter how high the company’s debt, if it can easily cover the interest payments, it’s considered to be efficient with its use of excess leverage. A company generating earnings before interest and tax (EBIT) at least three times its net interest payments is considered financially sound. In API's case, the ratio of 92.23x suggests that interest is comfortably covered, which means that lenders may be willing to lend out more funding as API’s high interest coverage is seen as responsible and safe practice.

Next Steps:

Although API’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. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. Keep in mind I haven't considered other factors such as how API has been performing in the past. You should continue to research Australian Pharmaceutical Industries to get a more holistic view of the small-cap by looking at:

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

2. Valuation: What is API 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 API 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.