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Zero-debt allows substantial financial flexibility, especially for small-cap companies like Korvest Ltd (ASX:KOV), as the company does not have to adhere to strict debt covenants. However, it also faces higher cost of capital given interest cost is generally lower than equity. While zero-debt makes the due diligence for potential investors less nerve-racking, it poses a new question: how should they assess the financial strength of such companies? I will take you through a few basic checks to assess the financial health of companies with no debt.
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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. 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 KOV’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 KOV is a high-growth company. KOV’s revenue growth over the past year is a double-digit 27% which is considerably high for a small-cap company. Therefore, the company’s decision to choose financial flexibility is justified as it may need headroom to borrow in the future to sustain high growth.
Does KOV’s liquid assets cover its short-term commitments?
Since Korvest 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. But another important aspect of financial health is liquidity: the company’s ability to meet short-term obligations, including payments to suppliers and employees. With current liabilities at AU$7.0m, the company has been able to meet these commitments with a current assets level of AU$25m, leading to a 3.55x current account ratio. However, many consider a ratio above 3x to be high, although this is not necessarily a bad thing.
Next Steps:
As a high-growth company, it may be beneficial for KOV 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. Going forward, its financial position may change. I admit this is a fairly basic analysis for KOV’s financial health. Other important fundamentals need to be considered alongside. You should continue to research Korvest to get a better picture of the stock by looking at: