Zero-debt allows substantial financial flexibility, especially for small-cap companies like Broken Hill Prospecting Limited (ASX:BPL), as the company does not have to adhere to strict debt covenants. However, it also faces higher cost of capital given interest cost is generally lower than equity. 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? I will take you through a few basic checks to assess the financial health of companies with no debt.
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Is BPL right in choosing financial flexibility over lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. Though, the trade-offs are that lenders require stricter capital management requirements, in addition to having a higher claim on company assets relative to shareholders. Either BPL does not have access to cheap capital, or it may believe this trade-off is not worth it. This makes sense only if the company has a competitive edge and is growing fast off its equity capital. Opposite to the high growth we were expecting, BPL’s negative revenue growth of -85% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can BPL meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Broken Hill Prospecting has no solvency issues, which is used to describe the company’s ability to meet its long-term obligations. However, another measure of financial health is its short-term obligations, which is known as liquidity. These include payments to suppliers, employees and other stakeholders. At the current liabilities level of AU$282k, it appears that the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 8.1x. Having said that, a ratio greater than 3x may be considered high by some.
Next Steps:
Given that Broken Hill Prospecting is a relatively low-growth company, not having any low-cost debt funding may not be optimal for the business. As an investor, you may want to figure out if there are company-specific reasons for not having any debt, and whether the company needs financial flexibility at this point in time. I admit this is a fairly basic analysis for BPL’s financial health. Other important fundamentals need to be considered alongside. You should continue to research Broken Hill Prospecting to get a more holistic view of the stock by looking at:
- Valuation: What is BPL worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether BPL is currently mispriced by the market.
- Historical Performance: What has BPL’s returns been like over the past? Go into more detail in the past track record analysis and take a look at the free visual representations of our analysis for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.