Including debt in the capital structure of companies such as Encounter Resources Limited (ASX:ENR), which has no debt, can improve its capital returns as the cost of capital comes down. The debt is less costly due to relatively less risk born by debtholders in the event of liquidation. Additionally, interest on debt reduces the tax liability.
A drop in the cost of capital beefs up a company’s valuation as the same is used to discount its future cash flows to arrive at the intrinsic value — an foresee of its worth right now. This is one of the reasons – given interest rates at record lows – that most companies tremendously raised debt in their capital structure over the past few years.
On the flip side, given the interest-rate hikes are a part of the economic cycle, Encounter Resources will be in a stronger position compared to companies which would have to reduce debt due to rising interest-costs in such a scenario. Although zero-debt makes Encounter Resources’s financial strength analysis lot more stressful, there are other metrics to check its financial health. Here are things I recommend you look at when assessing the financial health of companies no debt. View our latest analysis for Encounter Resources
Is Encounter Resources right in choosing financial flexibility instead of a lower cost of capital?
Zero-debt allows substantial financial flexibility, especially for small-cap companies like ENR with its market cap of USD $10 Million as they have limited capability of raising large sums through capital markets. However, this makes sense only if the company has a competitive edge and it’s growing fast. To fulfil this criteria, I expect a company to generate more than 20% revenue growth. In a complete contrast, ENR’s revenue contracted -23.1% over the past year. If the company is not expecting exceptional future growth, then its decision to avoid debt may cost shareholders dearly in the long-term.
Can ENR meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Encounter Resources has no solvency issues. Solvency is 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, which are mostly comprised of payments to suppliers, bank loans and debts due over the next twelve months. To cover them, a company must have more liquid assets than these obligations. In ENR’s case, its short-term assets of $4 Million exceed the short-term liabilities of $1 Million, indicating sound liquidity position.
Encounter Resources has no long-term balance sheet, so there’s no bankruptcy risk. Additionally, with its liquid assets exceeding the short-term obligations, the company faces no liquidity issues. However, the company’s -23.1% growth rate raises concern over its decision to remain a zero-debt company. Now I recommend you check out our latest free analysis report to see what are ENR’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Encounter Resources anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.