The direct benefit for Aeorema Communications plc (AIM:AEO), 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 AEO 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 AEO has outstanding financial strength. I will take you through a few basic checks to assess the financial health of companies with no debt. See our latest analysis for Aeorema Communications
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. 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. AEO’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. AEO delivered a negative revenue growth of -9.31%. While its negative growth hardly justifies opting for zero-debt, if the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does AEO’s liquid assets cover its short-term commitments?
Given zero long-term debt on its balance sheet, Aeorema Communications has no solvency issues, which is 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. Looking at AEO’s most recent £1.6M 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 1.76x. Usually, for media companies, this is a suitable ratio since there’s sufficient cash cushion without leaving too much capital idle or in low-earning investments.
Next Steps:
Are you a shareholder? AEO’s soft top-line growth means not having any low-cost debt funding may not be optimal for the business. 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. You should take a look into a future growth analysis to properly assess the company’s position.