CMI Limited (ASX:CMI), which has zero-debt on its balance sheet, can maximize capital returns by increasing debt due to its lower cost of capital. However, the trade-off is CMI will have to follow strict debt obligations which will reduce its financial flexibility. Zero-debt can alleviate some risk associated with the company meeting debt obligations, but this doesn’t automatically mean CMI has outstanding financial strength. I will take you through a few basic checks to assess the financial health of companies with no debt. View our latest analysis for CMI
Does CMI’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. The lack of debt on CMI’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 CMI is a high-growth company. CMI’s revenue growth over the past year is a single-digit 8.49% which is relatively low 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.
Does CMI’s liquid assets cover its short-term commitments?
Since CMI 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 CMI’s most recent A$6.4M liabilities, the company has been able to meet these commitments with a current assets level of A$41.9M, leading to a 6.5x current account ratio. Though, anything above 3x is considered high and could mean that CMI has too much idle capital in low-earning investments.
Next Steps:
Are you a shareholder? As CMI’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 recommend taking a look into a future growth analysis to examine the company’s position.