The direct benefit for Queensland Bauxite Limited (ASX:QBL), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. The cost of debt is always less than that of equity as debt-holders have a superior claim over the company’s assets. In addition, interest on debt brings down taxable income, reducing the tax paid.
A drop in the cost of capital beefs up a company’s valuation as the same is used to discount its future cash flows to arrive at the intrinsic value — an estimate of its worth right now. This is one of the reasons – given interest rates at record lows – that most companies tremendously raised debt in their capital structure over the past few years.
On the other hand, rate hikes are imminent, it’s a part of the broader economic cycle. No-debt companies will clearly be in a stronger cash position compared to companies of which most, if not all, will be forced to retire a chunk of their debt due to rising costs. Higher the interest rates, higher the cost of debt. 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? Here’s a small checklist which I believe provides a ballpark estimate of their financial health status.
For small-cap companies such as QBL with its market cap of USD $22 Million, financial flexibility is a valuable option. And currently operating on a smaller scale, they’re not wrong in choosing it over improved total shareholder returns. However, choosing financial flexibility over capital returns is logical only if it’s a high-growth company. To fulfil this criteria, I expect a company to generate more than 20% revenue growth. In a complete contrast, QBL’s revenue contracted -100% over the past year. If the company is not expecting exceptional future growth, then its decision to avoid debt may cost shareholders dearly in the long-term.
Given zero long-term debt on its balance sheet, Queensland Bauxite has no solvency issues. Solvency is 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, which are mostly comprised of payments to suppliers, bank loans and debts due over the next twelve months. To cover them, a company must have more liquid assets than these obligations. However, a look at QBL’s liquid assets of $7 Million and its short-term obligations of $0 Million due over the next year is indicating the company may face liquidity issues.
At the first glance, Queensland Bauxite appears to be a financially healthy company with almost no long-term debt on its balance sheet. But given its weak growth, its tough liquidity position with current liabilities exceeding current assets can pose serious financial threats in the short-term and you should keep the financial situation in mind as a risk factor. Now I recommend you check out our latest free analysis report to see what are QBL’s growth prospects and whether it could be considered an undervalued opportunity.