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The direct benefit for Drake Resources Limited (ASX:DRK), 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 DRK will have to adhere to stricter debt covenants and have less financial flexibility. While DRK has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. I recommend you look at the following hurdles to assess DRK’s financial health.
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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 DRK’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 DRK is a high-growth company. DRK delivered a strikingly high triple-digit revenue growth over the past year, so it is acceptable that the company is opting for a zero-debt capital structure currently as it may need to raise debt to fuel expansion in the future.
Can DRK meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Drake Resources has no solvency issues, which is 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 DRK’s most recent AU$147k liabilities, it appears that the company has been able to meet these commitments with a current assets level of AU$1m, leading to a 10x current account ratio. However, a ratio greater than 3x may be considered as quite high.
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DRK 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. In the future, DRK’s financial situation may change. I admit this is a fairly basic analysis for DRK’s financial health. Other important fundamentals need to be considered alongside. I recommend you continue to research Drake Resources to get a more holistic view of the stock by looking at: