The direct benefit for BP Prudhoe Bay Royalty Trust (NYSE:BPT), 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 BPT 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. See our latest analysis for BP Prudhoe Bay Royalty Trust
Is BPT 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. Either BPT 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. BPT delivered a negative revenue growth of -64.57%. While its negative growth hardly justifies opting for zero-debt, if the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does BPT’s liquid assets cover its short-term commitments?
Given zero long-term debt on its balance sheet, BP Prudhoe Bay Royalty Trust has no solvency issues, which is 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. With current liabilities at $0.2M liabilities, the company has been able to meet these commitments with a current assets level of $1.0M, leading to a 4.61x current account ratio. Though, a ratio greater than 3x may be considered as too high, as BPT could be holding too much capital in a low-return investment environment.
Are you a shareholder? BPT 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, its financial position may be different. You should always be keeping abreast of market expectations for BPT’s future growth.
Are you a potential investor? BP Prudhoe Bay Royalty Trust is a fast-growing company, making financial flexibility a valuable option for the company. Moreover, its high liquidity means the company should continue to operate smoothly in the case of adverse events. To gain more conviction in the stock, you need to further analyse the company’s track record. You should continue your analysis by taking a look at BPT’s past performance in order to determine for yourself whether its zero-debt position is justified.
To help readers see pass 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.