The direct benefit for Heron Resources Limited (ASX:HRR), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. The cost of debt is always less than that of equity as debt-holders have a superior claim over the company’s assets. In addition, interest on debt brings down taxable income, reducing the tax paid.
A lower cost of capital increases a company’s valuation as it is the discount rate applied on future cash flows to calculate the present value; thus, indicating higher capital returns. Precisely due to the same reason, companies raised debt in their capital structure with costs at record lows in a low interest rate environment. This improved their capital returns and they were rewarded with higher valuations.
On the flip side, given the interest-rate hikes are a part of the economic cycle, Heron 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. 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? Here’s a small checklist which I believe provides a ballpark estimate of their financial health status. See our latest analysis for HRR
Is Heron Resources right in choosing financial flexibility instead of a lower cost of capital?
For small-cap companies such as HRR with its market cap of USD $38 Million, financial flexibility is a valuable option. And currently operating on a smaller scale, they’re not wrong in choosing it over improved total shareholder returns. However, choosing financial flexibility over capital returns is logical only if it’s a high-growth company. To pass this criterion, I put a benchmark figure of 20% revenue growth for any company opting zero long-term debt versus the higher returns for shareholders. On the flip-side, HRR saw a -92.65% contraction in revenue over the past 12 months. While its low growth hardly justifies opting for zero-debt, if the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can HRR pay its short-term debts?
Given zero long-term debt on its balance sheet, Heron 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 HRR’s case, its short-term assets of $21 Million exceed the short-term liabilities of $1 Million, indicating sound liquidity position.
Heron 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 -92.65% 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 HRR’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Heron Resources anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.