Zero-debt allows substantial financial flexibility, especially for small-cap companies like Arco Platform Limited (NASDAQ:ARCE), 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 go over a basic overview of the stock’s financial health, which I believe provides a ballpark estimate of their financial health status.
Is ARCE right in choosing financial flexibility over lower cost of capital?
Debt funding can be cheaper than issuing new equity due to lower interest cost on debt. But the downside of having debt in a company’s balance sheet is the debtholder’s higher claim on its assets in the case of liquidation, as well as stricter capital management requirements. ARCE’s absence of debt on its balance sheet may be due to lack of access to cheaper capital, or it may simply believe low cost is not worth sacrificing financial flexibility. However, choosing flexibility over capital returns is logical only if it’s a high-growth company. A double-digit revenue growth of 35% is considered relatively high for a small-cap company like ARCE. So, it is acceptable that the company is opting for a zero-debt capital structure currently as it may need to raise debt to fuel expansion in the future.
Can ARCE pay its short-term liabilities?
Since Arco Platform 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. With current liabilities at R$63m, it appears that the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 15.95x. However, many consider a ratio above 3x to be high, although this is not necessarily a bad thing.
As a high-growth company, it may be beneficial for ARCE to have some financial flexibility, hence zero-debt. Since there is also no concerns around ARCE’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, ARCE’s financial situation may change. Keep in mind I haven’t considered other factors such as how ARCE has been performing in the past. I suggest you continue to research Arco Platform to get a better picture of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for ARCE’s future growth? Take a look at our free research report of analyst consensus for ARCE’s outlook.
- Valuation: What is ARCE 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 ARCE 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.