Energy Resources of Australia Ltd (ASX:ERA), 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 ERA will have to follow strict debt obligations which will reduce its financial flexibility. 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. Check out our latest analysis for Energy Resources of Australia
Is financial flexibility worth the 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 ERA’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 ERA is a high-growth company. ERA delivered a negative revenue growth of -15.34%. While its negative growth hardly justifies opting for zero-debt, if the decline sustains, it may find it hard to raise debt at an acceptable cost.
Can ERA meet its short-term obligations with the cash in hand?
Since Energy Resources of Australia 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 A$133.3M liabilities, the company has been able to meet these commitments with a current assets level of A$535.2M, leading to a 4.01x current account ratio. Though, anything above 3x is considered high and could mean that ERA has too much idle capital in low-earning investments.
Next Steps:
Are you a shareholder? Since ERA is a low-growth stock in terms of its revenues, being in a zero-debt position isn’t always optimal. As shareholders, you should try and determine whether this strategy is justified for ERA, and whether the company needs financial flexibility at this point in time. You should take a look into a future growth analysis to account for the company’s position.