Zero-debt allows substantial financial flexibility, especially for small-cap companies like Resonance Health Limited (ASX:RHT), 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 RHT 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. Check out our latest analysis for Resonance Health
Is RHT 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. 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 RHT’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 RHT is a high-growth company. Opposite to the high growth we were expecting, RHT’s negative revenue growth of -1.66% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does RHT’s liquid assets cover its short-term commitments?
Since Resonance Health 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. At the current liabilities level of A$0.9M liabilities, it appears that the company has been able to meet these obligations given the level of current assets of A$2.3M, with a current ratio of 2.63x. Generally, for medical equipment 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? Since RHT is a low-growth stock in terms of its revenues, 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 whether the company needs financial flexibility at this point in time. I recommend taking a look into a future growth analysis to properly assess the company’s position.