Including debt in the capital structure of companies such as Absolute Software Corporation (TSX:ABT), 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 estimate of its worth right now. 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 other hand, rate hikes are imminent, it’s a part of the broader economic cycle. No-debt companies will clearly be in a stronger cash position compared to companies of which most, if not all, will be forced to retire a chunk of their debt due to rising costs. Higher the interest rates, higher the cost of debt. Although zero-debt makes Absolute Software’s financial strength analysis lot more stressful, there are other metrics to check its financial health. These are a few basic checks to assess the financial health of companies with no debt. View our latest analysis for Absolute Software
Can Absolute Software’s growth rate justify focus on financial flexibility over lower cost of capital?
Zero-debt allows substantial financial flexibility, especially for small-cap companies like ABT with its market cap of USD $208 Million as they have limited capability of raising large sums through capital markets. 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, ABT saw a -7.56% 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 ABT pay its short-term debts?
Given zero long-term debt on its balance sheet, Absolute Software 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 ABT’s liquid assets of $47 Million and its short-term obligations of $83 Million due over the next year is indicating the company may face liquidity issues.
At the first glance, Absolute Software appears to be a financially healthy company with almost no long-term debt on its balance sheet. But given its weak growth, its tough liquidity position with current liabilities exceeding current assets can pose serious financial threats in the short-term 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 ABT’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Absolute Software anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.