The direct benefit for Ilika plc (LON:IKA), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. However, the trade-off is IKA will have to adhere to stricter debt covenants and have less financial flexibility. 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 IKA right in choosing 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. Either IKA does not have access to cheap capital, or it may believe this trade-off is not worth it. This makes sense only if the company has a competitive edge and is growing fast off its equity capital. IKA’s revenue growth over the past year is an impressively high double-digit 95%. Therefore, the company’s decision to choose financial flexibility is justified as it may need headroom to borrow in the future to sustain high growth.
Can IKA pay its short-term liabilities?
Given zero long-term debt on its balance sheet, Ilika 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. At the current liabilities level of UK£960k, it seems that the business has been able to meet these commitments with a current assets level of UK£4.2m, leading to a 4.34x current account ratio. However, a ratio greater than 3x may be considered high by some.
IKA is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. Moving forward, IKA’s financial situation may change. This is only a rough assessment of financial health, and I’m sure IKA has company-specific issues impacting its capital structure decisions. I recommend you continue to research Ilika to get a better picture of the stock by looking at:
- Historical Performance: What has IKA’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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.