Small-cap companies such as Encanto Potash Corp (TSXV:EPO) with its market cap of USD $33 Million, benefit the most from improving economic conditions due to the growth potential, but on the other hand they also are highly prone to a downturn, thus making their financial strength an important factor in filtering out the risky ones. Although EPO’s low debt-to-equity ratio of 34.9% indicates financial strength, there’s more to it than just one ratio.
One of the major reasons that they are highly affected by a downturn in the country’s economy or an industry in the region is the lack of geographic diversification. So, investors often choose small-cap funds. On the other hand, well-versed investors allocate a small part of their portfolio capital to individual small-caps, primarily to improve its risk-return profile. However, that doesn’t reduce the risks these companies face individually. But I believe that it can be reduced to some extent by looking at these back of the hand balance sheet calculations. See our latest analysis for EPO
Does Encanto Potash’s liquidity position also indicate financial strength?
Even the most successful companies face downturn as competitors, consumers and disruptors keep reshaping markets, but they survive due to their strong liquidity position (and also the ability to adjust quickly). Comparing Encanto Potash’s liquid assets to its debt would let me know if it’s resilient enough. EPO’s current assets ($1M) are less than half its total debt ($7M). The company’s current assets to total debt ratio isn’t at a satisfactory level (1) and a major downturn can raise serious concerns about its ability to survive.
Can EPO easily service its debt with what it earns?
One of the key checks of Encanto Potash’s financial health is to compare what it earns against the amount it pays as interest. This highlights the company’s ability to service debt during a downturn.I consider an earnings to interest expense multiple of more than five an indication of financial strength as the company can easily meet its debt obligations, even during a tough time. For EPO, the company is making a loss, therefore interest on debt is not well covered by earnings.
Clearly, Encanto Potash has a significantly low debt on its balance sheet. The company fails to impress in terms of generating strong enough operating cash flows or earnings. Thus, for now, I don’t find it a financially sound company. Now when you know whether you should keep the debt in mind as a risk factor when putting together your investment thesis, I recommend you check out our latest free analysis report on Encanto Potash to see what are EPO’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Encanto Potash anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.