The direct benefit for Highway Holdings Limited (NASDAQ:HIHO), 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 HIHO will have to adhere to stricter debt covenants and have less financial flexibility. While HIHO has no debt on its balance sheet, it doesn’t necessarily mean it exhibits 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 Highway Holdings
Is HIHO right in choosing financial flexibility over lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. 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. HIHO’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, HIHO’s negative revenue growth of -14.53% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does HIHO’s liquid assets cover its short-term commitments?
Given zero long-term debt on its balance sheet, Highway Holdings has no solvency issues, which is 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 $6.2M liabilities, the company has been able to meet these commitments with a current assets level of $16.4M, leading to a 2.64x current account ratio. Generally, for machinery companies, this is a reasonable ratio as there’s enough of a cash buffer without holding too capital in low return investments.
Next Steps:
Are you a shareholder? Given that Highway Holdings is a relatively low-growth company, 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. You should take a look into a future growth analysis to properly assess what the market expects for the company moving forward.