The direct benefit for Far East Holdings International Limited (SEHK:36), which sports a zero-debt capital structure, to include debt in its capital structure is the reduced cost of capital. However, the trade-off is 36 will have to adhere to stricter debt covenants and have less 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 Far East Holdings International
Is financial flexibility worth the lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. 36’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. 36 delivered a negative revenue growth of -2.07%. 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.
Does 36’s liquid assets cover its short-term commitments?
Since Far East Holdings International 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. With current liabilities at HK$3.9M, the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 193.05x. Though, anything about 3x may be excessive, since 36 may be leaving too much capital in low-earning investments.
Next Steps:
Are you a shareholder? 36’s soft top-line growth means having no debt on its balance sheet isn’t necessarily the best thing. 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 suggest you take a look into a future growth analysis to examine what the market expects for the company moving forward.