Discovery Africa Limited (ASX:DAF), 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 DAF 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 DAF has outstanding financial strength. 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. View our latest analysis for Discovery Africa
Is DAF right in choosing financial flexibility over lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. Either DAF does not have access to cheap capital, or it may believe this trade-off is not worth it. This makes sense only if the company has a competitive edge and is growing fast off its equity capital. A double-digit revenue growth of 21.06% is considered relatively high for a small-cap company like DAF. 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 DAF meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Discovery Africa 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 DAF’s most recent A$0.3M liabilities, it appears that the company has been able to meet these obligations given the level of current assets of A$1.7M, with a current ratio of 6.23x. Though, a ratio greater than 3x may be considered as too high, as DAF could be holding too much capital in a low-return investment environment.
Next Steps:
Are you a shareholder? As a high-growth company, it may be beneficial for DAF to have some financial flexibility, hence zero-debt. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. In the future, its financial position may be different. I recommend researching market expectations for DAF’s future growth.
Are you a potential investor? Discovery Africa is a fast-growing company, making financial flexibility a valuable option for the company. Moreover, its high liquidity means the company should continue to operate smoothly in the case of adverse events. In order to build your confidence in the stock, you need to also analyse DAF’s track record. As a following step, you should take a look at DAF’s past performance to conclude on DAF’s financial health.
To help readers see pass 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.