The direct benefit for Sunstone Metals Limited (ASX:STM), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. However, the trade-off is STM will have to adhere to stricter debt covenants and have less financial flexibility. Zero-debt can alleviate some risk associated with the company meeting debt obligations, but this doesn’t automatically mean STM has outstanding financial strength. I will go over a basic overview of the stock’s financial health, which I believe provides a ballpark estimate of their financial health status.
Is financial flexibility worth the lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. Either STM 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, STM’s negative revenue growth of -43% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can STM pay its short-term liabilities?
Given zero long-term debt on its balance sheet, Sunstone Metals has no solvency issues, which is used to describe 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, including payments to suppliers and employees. With current liabilities at AU$310k, the company has been able to meet these commitments with a current assets level of AU$2.7m, leading to a 8.81x current account ratio. Having said that, a ratio above 3x may be considered excessive by some investors.
As a high-growth company, it may be beneficial for STM to have some financial flexibility, hence zero-debt. Since there is also no concerns around STM’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, its financial position may be different. Keep in mind I haven’t considered other factors such as how STM has been performing in the past. I recommend you continue to research Sunstone Metals to get a better picture of the stock by looking at:
- Historical Performance: What has STM’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.
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