Are Nine Dragons Paper (Holdings) Limited's (HKG:2689) Interest Costs Too High?
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While small-cap stocks, such as Nine Dragons Paper (Holdings) Limited (HKG:2689) with its market cap of HK$29b, are popular for their explosive growth, investors should also be aware of their balance sheet to judge whether the company can survive a downturn. Evaluating financial health as part of your investment thesis is vital, 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. Nevertheless, this is not a comprehensive overview, so I recommend you dig deeper yourself into 2689 here.
2689’s Debt (And Cash Flows)
Over the past year, 2689 has ramped up its debt from CN¥29b to CN¥33b – this includes long-term debt. With this rise in debt, the current cash and short-term investment levels stands at CN¥9.8b to keep the business going. On top of this, 2689 has produced CN¥9.1b in operating cash flow in the last twelve months, leading to an operating cash to total debt ratio of 28%, indicating that 2689’s current level of operating cash is high enough to cover debt.
Does 2689’s liquid assets cover its short-term commitments?
Looking at 2689’s CN¥24b in current liabilities, it appears that the company has been able to meet these obligations given the level of current assets of CN¥25b, with a current ratio of 1.05x. The current ratio is calculated by dividing current assets by current liabilities. For Forestry 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 2689 service its debt comfortably?
2689 is a relatively highly levered company with a debt-to-equity of 90%. 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 2689's case, the ratio of 10.45x suggests that interest is comfortably covered, which means that debtors may be willing to loan the company more money, giving 2689 ample headroom to grow its debt facilities.
Next Steps:
Although 2689’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. Since there is also no concerns around 2689'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 2689 has been performing in the past. I suggest you continue to research Nine Dragons Paper (Holdings) to get a better picture of the small-cap by looking at:
Future Outlook: What are well-informed industry analysts predicting for 2689’s future growth? Take a look at our free research report of analyst consensus for 2689’s outlook.
Valuation: What is 2689 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 2689 is currently mispriced by the market.
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.
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