Zero-debt allows substantial financial flexibility, especially for small-cap companies like Hotcopper Holdings Limited (ASX:HOT), 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.
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 HOT 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. HOT’s revenue growth over the past year is a double-digit 28% which is considerably high for a small-cap company. Therefore, the company’s decision to choose financial flexibility is justified as it may need headroom to borrow in the future to sustain high growth.
Can HOT pay its short-term liabilities?
Given zero long-term debt on its balance sheet, Hotcopper Holdings 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. At the current liabilities level of AU$1.7m, the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 2.5x. Generally, for Interactive Media and Services companies, this is a reasonable ratio as there’s enough of a cash buffer without holding too much capital in low return investments.
As a high-growth company, it may be beneficial for HOT to have some financial flexibility, hence zero-debt. Since there is also no concerns around HOT’s liquidity needs, this may be its optimal capital structure for the time being. In the future, its financial position may change. This is only a rough assessment of financial health, and I’m sure HOT has company-specific issues impacting its capital structure decisions. I suggest you continue to research Hotcopper Holdings to get a more holistic view of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for HOT’s future growth? Take a look at our free research report of analyst consensus for HOT’s outlook.
- Valuation: What is HOT 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 HOT is currently mispriced by the market.
- 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 email@example.com.