Eastern Iron Limited (ASX:EFE), 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 EFE will have to follow strict debt obligations which will reduce its financial flexibility. While EFE 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. View our latest analysis for Eastern Iron
Does EFE’s growth rate justify its decision for 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. The lack of debt on EFE’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 EFE is a high-growth company. EFE’s revenue growth over the past year is a single-digit 9.14% 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 EFE’s liquid assets cover its short-term commitments?
Since Eastern Iron 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. Looking at EFE’s most recent A$0.1M liabilities, the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 22.25x. Though, a ratio greater than 3x may be considered as too high, as EFE could be holding too much capital in a low-return investment environment.
Next Steps:
Are you a shareholder? EFE’s soft top-line growth means not taking advantage of lower cost debt may not be the best strategy. Shareholders should understand why the company isn’t opting for cheaper cost of capital to fund future growth, and why financial flexibility is needed at this stage in its business cycle. I suggest you take a look into a future growth analysis to examine what the market expects for the company moving forward.