The direct benefit for 3D Oil Limited (ASX:TDO), 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 TDO will have to adhere to stricter debt covenants and have less financial flexibility. Zero-debt can alleviate some risk associated with the company meeting debt obligations, but this doesn’t automatically mean TDO has outstanding financial strength. I will take you through a few basic checks to assess the financial health of companies with no debt. Check out our latest analysis for 3D Oil
Is TDO 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 TDO’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 TDO is a high-growth company. Opposite to the high growth we were expecting, TDO’s negative revenue growth of -80.16% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does TDO’s liquid assets cover its short-term commitments?
Since 3D Oil 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 TDO’s most recent A$0.9M liabilities, the company has been able to meet these obligations given the level of current assets of A$2.4M, with a current ratio of 2.59x. Generally, for oil, gas and consumable fuels companies, this is a reasonable ratio since there’s sufficient cash cushion without leaving too much capital idle or in low-earning investments.
Next Steps:
Are you a shareholder? As TDO’s revenues are not growing at a fast enough pace, not taking advantage of lower cost debt may not be the best strategy. As an investor, you may want to figure out if there are company-specific reasons for not having any debt, and whether the company needs financial flexibility at this point in time. I suggest you take a look into a future growth analysis to properly assess what the market expects for the company moving forward.