The direct benefit for E2 Metals Limited (ASX:E2M), 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 E2M 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 recommend you look at the following hurdles to assess E2M’s financial health.
Is E2M 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. Though, the trade-offs are that lenders require stricter capital management requirements, in addition to having a higher claim on company assets relative to shareholders. The lack of debt on E2M’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 E2M is a high-growth company. E2M delivered a strikingly high triple-digit revenue growth over the past year, 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 E2M pay its short-term liabilities?
Since E2 Metals 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. At the current liabilities level of AU$82k, it appears that the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 45.91x. Having said that, a ratio greater than 3x may be considered high by some.
E2M 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. In the future, its financial position may be different. This is only a rough assessment of financial health, and I’m sure E2M has company-specific issues impacting its capital structure decisions. I recommend you continue to research E2 Metals to get a better picture of the stock by looking at:
- Historical Performance: What has E2M’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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