Investors are always looking for growth in small-cap stocks like Honworld Group Limited (HKG:2226), with a market cap of HK$1.9b. However, an important fact which most ignore is: how financially healthy is the business? So, understanding the company’s financial health becomes crucial, as mismanagement of capital can lead to bankruptcies, which occur at a higher rate for small-caps. Here are few basic financial health checks you should consider before taking the plunge. Nevertheless, since I only look at basic financial figures, I suggest you dig deeper yourself into 2226 here.

How does 2226’s operating cash flow stack up against its debt?

2226 has built up its total debt levels in the last twelve months, from CN¥853m to CN¥983m – this includes long-term debt. With this growth in debt, 2226’s cash and short-term investments stands at CN¥374m for investing into the business. Additionally, 2226 has produced CN¥281m in operating cash flow in the last twelve months, leading to an operating cash to total debt ratio of 29%, signalling that 2226’s debt is appropriately covered by operating cash. This ratio can also be a sign of operational efficiency as an alternative to return on assets. In 2226’s case, it is able to generate 0.29x cash from its debt capital.

Does 2226’s liquid assets cover its short-term commitments?

At the current liabilities level of CN¥1.1b, it appears that the company has been able to meet these obligations given the level of current assets of CN¥2.0b, with a current ratio of 1.91x. For Food 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 2226 service its debt comfortably?

With debt reaching 47% of equity, 2226 may be thought of as relatively highly levered. This is not unusual for small-caps as debt tends to be a cheaper and faster source of funding for some businesses. We can check to see whether 2226 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 2226’s, case, the ratio of 5.39x suggests that interest is appropriately covered, which means that debtors may be willing to loan the company more money, giving 2226 ample headroom to grow its debt facilities.

Next Steps:

Although 2226’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. This is only a rough assessment of financial health, and I’m sure 2226 has company-specific issues impacting its capital structure decisions. You should continue to research Honworld Group to get a more holistic view of the small-cap by looking at:

1. Future Outlook: What are well-informed industry analysts predicting for 2226’s future growth? Take a look at our free research report of analyst consensus for 2226’s outlook.

2. Historical Performance: What has 2226’s returns been like over the past? Go into more detail in the past track record analysis and take a look at the free visual representations of our analysis for more clarity.

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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.