Any company, including EXFO Inc (TSX:EXF) 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. 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, EXFO 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. View our latest analysis for EXFO
Can EXFO’s growth rate justify focus on financial flexibility over lower cost of capital?
For small-cap companies such as EXF with its market cap of USD $257 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. EXF, with its revenue growth of 4.73% over the past year, falls short of my expectations of 20%, which I set as a benchmark to pass this criterion. But it must have some high-growth projects in place for choosing low capital returns and high flexibility. Find out what analysts think of its growth potential.
Can EXF meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, EXFO 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 EXF’s case, its short-term assets of $135 Million exceed the short-term liabilities of $48 Million, indicating sound liquidity position.
EXFO 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 4.73% 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 EXF’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in EXFO anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.