Zero-debt allows substantial financial flexibility, especially for small-cap companies like Neuren Pharmaceuticals Limited (ASX:NEU), 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 NEU right in choosing financial flexibility over lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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. The lack of debt on NEU’s balance sheet may be because it does not have access to cheap capital, or it may believe this trade-off is not worth it. Choosing financial flexibility over capital returns make sense if NEU is a high-growth company. Opposite to the high growth we were expecting, NEU’s negative revenue growth of -79% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can NEU pay its short-term liabilities?
Since Neuren Pharmaceuticals doesn’t have any debt on its balance sheet, it doesn’t have any solvency issues, which is a term 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$1m liabilities, the company has been able to meet these commitments with a current assets level of AU$19m, leading to a 14.49x current account ratio. However, anything above 3x may be considered excessive by some investors. They might argue NEU is leaving too much capital in low-earning investments.
Having no debt on the books means NEU has more financial freedom to keep growing at its current fast rate. Since there is also no concerns around NEU’s liquidity needs, this may be its optimal capital structure for the time being. In the future, its financial position may change. Keep in mind I haven’t considered other factors such as how NEU has been performing in the past. You should continue to research Neuren Pharmaceuticals to get a more holistic view of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for NEU’s future growth? Take a look at our free research report of analyst consensus for NEU’s outlook.
- Historical Performance: What has NEU’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 firstname.lastname@example.org.