While small-cap stocks, such as GTN Limited (ASX:GTN) with its market cap of USD $463 Million, are popular for their explosive growth, investors should also pay heed to 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.
Apart from geopolitical events such as political unrest and natural calamities, a company which is suddenly facing a hostile market environment must be able to fulfil short-term commitments with its reserves so that it can see another day. These factors make a basic understanding of a company’s financial position of utmost importance for a new investor. Here are a few basic checks that are good enough to have a broad overview of the company’s financial strength. View our latest analysis for GTN
Does GTN generate an acceptable amount of cash through operations?
More than the revenue shown on paper, what matters is how much cash is generated through operations and whether it is enough to continue operations, meet debt-obligations and fund growth . For GTN the ratio of operating cash flow to overall debt stands at 4.1%. An annual operating cash flow of less than a tenth of the overall debt raises red flags, although short-term obstacles and cyclical nature of an industry may have an impact on a company’s ability to generate cash.
Can GTN meet its short-term obligations with the cash in hand?
There are many problems that come unannounced. For instance, a hurricane or even labor strikes. In 2011, a Tsunami and earthquake in Japan had wiped out a significant chunk of auto supply chain in the country. If these were not Japan’s biggest automakers and electronics-maker with big cash reserves and funding sources, it’s hard to imagine how would they have recovered . For a small company, that could be a death blow if it doesn’t have enough reserves to meet its short-term obligations – payments to suppliers, wages, short-term bank loans, interest on long-term debt. GTN is able to meet its short term (1 year) commitments with its holdings of cash and other short term assets.
Does GTN face the risk of succumbing to its debt-load?
While ideally I reckon the debt-to equity ratio of a financially healthy company to be less than 40%, several factors such as industry life-cycle and economic conditions can result in a company raising a significant amount of debt. For GTN, the debt to equity ratio is 45% and that means GTN hardly has any risk of facing a debt-overhang . No matter how high is the debt, if a company can easily cover the interest payments, it’s considered to be making a good use of that excessive leverage. To keep an eye on how it’s doing on that front, an investor can check how easily the company can service its debt. If it earns at least 5x or more of its interest payments, that’s an indication of financial strength. In GTN’s case the company is making a loss, therefore interest on debt is not well covered by earnings.
Conclusion
Understanding a company’s financial strength goes a long way in reducing overall portfolio risk as these are the companies which can rebound from adverse operating conditions. What else an investor should look for: how is its track record; is it growing; and finally, is it overpriced or is it trading at an acceptable price based on fundamentals. I recommend you take a look at our FREE complete analysis report on GTN.
