Emerald Resources NL (ASX:EMR), 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 EMR will have to follow strict debt obligations which will reduce its 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 EMR right in choosing financial flexibility over lower cost of capital?
Debt funding can be cheaper than issuing new equity due to lower interest cost on debt. 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. Either EMR 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. Opposite to the high growth we were expecting, EMR’s negative revenue growth of -64% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can EMR pay its short-term liabilities?
Since Emerald Resources 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 EMR’s most recent AU$783k liabilities, it appears that the company has been able to meet these obligations given the level of current assets of AU$1.8m, with a current ratio of 2.31x. Generally, for Metals and Mining companies, this is a reasonable ratio since there is a bit of a cash buffer without leaving too much capital in a low-return environment.
As a high-growth company, it may be beneficial for EMR to have some financial flexibility, hence zero-debt. Since there is also no concerns around EMR’s liquidity needs, this may be its optimal capital structure for the time being. Going forward, EMR’s financial situation may change. Keep in mind I haven’t considered other factors such as how EMR has been performing in the past. I suggest you continue to research Emerald Resources to get a more holistic view of the stock by looking at:
- Historical Performance: What has EMR’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 firstname.lastname@example.org.