The direct benefit for San Juan Basin Royalty Trust (NYSE:SJT), 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 SJT will have to adhere to stricter debt covenants and have less financial flexibility. 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 recommend you look at the following hurdles to assess SJT’s financial health. Check out our latest analysis for San Juan Basin Royalty Trust
Does SJT’s growth rate justify its decision for financial flexibility over lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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. SJT’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. Opposite to the high growth we were expecting, SJT’s negative revenue growth of -10.21% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can SJT meet its short-term obligations with the cash in hand?
Since San Juan Basin Royalty Trust 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 $2.9M liabilities, the company has been able to meet these obligations given the level of current assets of $3.9M, with a current ratio of 1.34x. Generally, for oil and gas companies, this is a reasonable ratio as there’s enough of a cash buffer without holding too capital in low return investments.
Are you a shareholder? SJT is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. Moving forward, its financial position may be different. I suggest keeping on top of market expectations for SJT’s future growth.
Are you a potential investor? SJT’s high growth makes financial flexibility an attractive option. Moreover, its high liquidity means the company should continue to operate smoothly in the case of adverse events. To gain more conviction in the stock, you need to further analyse SJT’s track record. I encourage you to continue your research by taking a look at SJT’s past performance to conclude on SJT’s financial health.