The direct benefit for Nearmap Ltd (ASX:NEA), 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, Nearmap 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 Nearmap’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. See our latest analysis for NEA
Is Nearmap growing fast enough to value financial flexibility over lower cost of capital?
For small-cap companies such as NEA with its market cap of USD $176 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. Given NEA’s revenue growth stood at 30.29% over the past year, the company’s decision to choose financial flexibility compared to increasing capital returns makes sense as it may need that funding under expected circumstances or to invest in more lucrative projects to fuel growth further.
Can NEA meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Nearmap 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. However, a look at NEA’s liquid assets of $18 Million and its short-term obligations of $23 Million due over the next year is indicating the company may face liquidity issues.
Given Nearmap’s revenue growth of 30.29%, financial flexibility is a highly valuable option for the company. But it stands to face liquidity issues as its short-term obligations exceed current assets. Thus, despite high growth, it’s not as financially strong as its zero-debt on its balance sheet indicates and you should keep the financial situation in mind as a risk factor. Now I recommend you check out our latest free analysis report to see what are NEA’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Nearmap anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.