Zero-debt allows substantial financial flexibility, especially for small-cap companies like Silicom Ltd (NASDAQ:SILC), as the company does not have to adhere to strict debt covenants. However, it also faces higher cost of capital given interest cost is generally lower than equity. While SILC 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. 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. SILC’s absence of debt on its balance sheet may be due to lack of access to cheaper capital, or it may simply believe low cost is not worth sacrificing financial flexibility. However, choosing flexibility over capital returns is logical only if it’s a high-growth company. SILC’s revenue growth in the teens of 17% is not considered as high-growth, especially for a small-cap company. While its low growth hardly justifies opting for zero-debt, the company may have high growth projects in the pipeline to justify the trade-off.
Can SILC meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Silicom 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 US$22m, it appears that the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 5.26x. Having said that, a ratio greater than 3x may be considered as quite high, and some might argue SILC could be holding too much capital in a low-return investment environment.
As a high-growth company, it may be beneficial for SILC to have some financial flexibility, hence zero-debt. Since there is also no concerns around SILC’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, its financial position may be different. I admit this is a fairly basic analysis for SILC’s financial health. Other important fundamentals need to be considered alongside. You should continue to research Silicom to get a more holistic view of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for SILC’s future growth? Take a look at our free research report of analyst consensus for SILC’s outlook.
- Valuation: What is SILC worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether SILC is currently mispriced by the market.
- 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.