Any company, including NXT Energy Solutions Inc (TSX:SFD) with no debt in its capital structure, would maximize capital returns by having an optimal capital structure, which includes debt. The debt reduces the overall cost of capital for the company. Due to its tax-benefits and legally-binding nature, it always costs less than equity.
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. 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 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. 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 SFD
Is growth fast enough to value financial flexibility over lower cost of capital?
Zero-debt allows substantial financial flexibility, especially for small-cap companies like SFD with its market cap of USD $46 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 fulfil this criteria, I expect a company to generate more than 20% revenue growth. In a complete contrast, SFD’s revenue contracted -91.69% 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 SFD meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, NXT Energy Solutions 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 SFD’s case, its short-term assets of $2 Million exceed the short-term liabilities of $1 Million, indicating sound liquidity position.
NXT Energy Solutions has no long-term debt on its 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 -91.69% 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 SFD’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in NXT Energy Solutions anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.