The direct benefit for Solution Dynamics Limited (NZSE:SDL), 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 SDL will have to adhere to stricter debt covenants and have less financial flexibility. While SDL has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. 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?
Debt funding can be cheaper than issuing new equity due to lower interest cost on debt. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. Either SDL 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. SDL’s revenue growth in the teens of 13% is not considered as high-growth, especially for a small-cap company. While its low growth hardly justifies opting for zero-debt, the company may have high growth projects in the pipeline to justify the trade-off.
Can SDL meet its short-term obligations with the cash in hand?
Since Solution Dynamics 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. 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. Looking at SDL’s NZ$4.0m in current liabilities, it appears that the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 1.28x. Usually, for IT companies, this is a suitable ratio since there is a bit of a cash buffer without leaving too much capital in a low-return environment.
Having no debt on the books means SDL has more financial freedom to keep growing at its current fast rate. Since there is also no concerns around SDL’s liquidity needs, this may be its optimal capital structure for the time being. In the future, SDL’s financial situation may change. I admit this is a fairly basic analysis for SDL’s financial health. Other important fundamentals need to be considered alongside. I suggest you continue to research Solution Dynamics to get a more holistic view of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for SDL’s future growth? Take a look at our free research report of analyst consensus for SDL’s outlook.
- Valuation: What is SDL 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 SDL 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 firstname.lastname@example.org.