Zero-debt allows substantial financial flexibility, especially for small-cap companies like PacRay International Holdings Limited (SEHK:1010), 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 recommend you look at the following hurdles to assess 1010’s financial health. Check out our latest analysis for PacRay International Holdings
Is financial flexibility worth the lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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. 1010’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. A double-digit revenue growth of 27.35% is considered relatively high for a small-cap company like 1010. 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 1010’s liquid assets cover its short-term commitments?
Since PacRay International Holdings 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. 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. Looking at 1010’s most recent HK$2.6M liabilities, it seems that the business has been able to meet these obligations given the level of current assets of HK$105.9M, with a current ratio of 40.76x. However, anything about 3x may be excessive, since 1010 may be leaving too much capital in low-earning investments.
Next Steps:
Are you a shareholder? 1010 is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. Moving forward, 1010’s financial situation may change. I suggest keeping abreast of market expectations for 1010’s future growth.