Element 25 Limited (ASX:E25), which has zero-debt on its balance sheet, can maximize capital returns by increasing debt due to its lower cost of capital. However, the trade-off is E25 will have to follow strict debt obligations which will reduce its financial flexibility. While E25 has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. I recommend you look at the following hurdles to assess E25’s financial health.
Is E25 growing fast enough to value financial flexibility over lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. But the downside of having debt in a company’s balance sheet is the debtholder’s higher claim on its assets in the case of liquidation, as well as stricter capital management requirements. The lack of debt on E25’s balance sheet may be because it does not have access to cheap capital, or it may believe this trade-off is not worth it. Choosing financial flexibility over capital returns make sense if E25 is a high-growth company. Opposite to the high growth we were expecting, E25’s negative revenue growth of -39% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does E25’s liquid assets cover its short-term commitments?
Since Element 25 doesn’t have any debt on its balance sheet, it doesn’t have any solvency issues, which is a term used to describe the company’s ability to meet its long-term obligations. But another important aspect of financial health is liquidity: the company’s ability to meet short-term obligations, including payments to suppliers and employees. Looking at E25’s AU$230k in current liabilities, it seems that the business has been able to meet these commitments with a current assets level of AU$9.9m, leading to a 43.21x current account ratio. Having said that, a ratio greater than 3x may be considered high by some.
Having no debt on the books means E25 has more financial freedom to keep growing at its current fast rate. Since there is also no concerns around E25’s liquidity needs, this may be its optimal capital structure for the time being. In the future, its financial position may be different. This is only a rough assessment of financial health, and I’m sure E25 has company-specific issues impacting its capital structure decisions. I suggest you continue to research Element 25 to get a more holistic view of the stock by looking at:
- Historical Performance: What has E25’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.
- 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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