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Cauldron Energy Limited (ASX:CXU), which has zero-debt on its balance sheet, can maximize capital returns by increasing debt due to its lower cost of capital. However, the trade-off is CXU will have to follow strict debt obligations which will reduce its 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 go over a basic overview of the stock’s financial health, which I believe provides a ballpark estimate of their financial health status.

See our latest analysis for Cauldron Energy

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. The lack of debt on CXU’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 CXU is a high-growth company. CXU delivered a negative revenue growth of -35%. 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 CXU’s liquid assets cover its short-term commitments?

Since Cauldron Energy 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. At the current liabilities level of AU$706k, it seems that the business has been able to meet these commitments with a current assets level of AU$5.1m, leading to a 7.2x current account ratio. Having said that, a ratio above 3x may be considered excessive by some investors, yet this is not usually a major negative for a company.

Next Steps:

CXU is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. Since there is also no concerns around CXU’s liquidity needs, this may be its optimal capital structure for the time being. In the future, its financial position may be different. This is only a rough assessment of financial health, and I’m sure CXU has company-specific issues impacting its capital structure decisions. I recommend you continue to research Cauldron Energy to get a better picture of the stock by looking at:

1. Historical Performance: What has CXU’s returns been like over the past? Go into more detail in the past track record analysis and take a look at the free visual representations of our analysis for more clarity.

2. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.