Sunstone Metals Limited (ASX:STM), 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 STM will have to follow strict debt obligations which will reduce its financial flexibility. While STM has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. 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 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. The lack of debt on STM’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 STM is a high-growth company. Opposite to the high growth we were expecting, STM’s negative revenue growth of -43.0% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can STM pay its short-term liabilities?
Given zero long-term debt on its balance sheet, Sunstone Metals 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 AU$310.3k liabilities, it seems that the business has been able to meet these obligations given the level of current assets of AU$2.7m, with a current ratio of 8.81x. However, a ratio greater than 3x may be considered as too high, as STM could be holding too much capital in a low-return investment environment.
As a high-growth company, it may be beneficial for STM to have some financial flexibility, hence zero-debt. 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, STM’s financial situation may change. Keep in mind I haven’t considered other factors such as how STM has been performing in the past. You should continue to research Sunstone Metals to get a better picture of the stock by looking at:
- Historical Performance: What has STM’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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