Zero-debt allows substantial financial flexibility, especially for small-cap companies like HKE Holdings Limited (HKG:1726), as the company does not have to adhere to strict debt covenants. However, it also faces higher cost of capital given interest cost is generally lower than equity. While zero-debt makes the due diligence for potential investors less nerve-racking, it poses a new question: how should they assess the financial strength of such companies? I will take you through a few basic checks to assess the financial health of companies with no debt.
Is financial flexibility worth the lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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 1726’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 1726 is a high-growth company. Opposite to the high growth we were expecting, 1726’s negative revenue growth of -23% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can 1726 meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, HKE Holdings has no solvency issues, which is used to describe the company’s ability to meet its long-term obligations. However, another measure of financial health is its short-term obligations, which is known as liquidity. These include payments to suppliers, employees and other stakeholders. Looking at 1726’s S$2.0m in current liabilities, it appears that the company has been able to meet these commitments with a current assets level of S$28m, leading to a 14.47x current account ratio. Having said that, a ratio greater than 3x may be considered by some to be quite high, however this is not necessarily a negative for the company.
As a high-growth company, it may be beneficial for 1726 to have some financial flexibility, hence zero-debt. Since there is also no concerns around 1726’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, its financial position may change. Keep in mind I haven’t considered other factors such as how 1726 has been performing in the past. You should continue to research HKE Holdings to get a better picture of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for 1726’s future growth? Take a look at our free research report of analyst consensus for 1726’s outlook.
- Valuation: What is 1726 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 1726 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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.