Kina Petroleum Limited (ASX:KPL), 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 KPL 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 take you through a few basic checks to assess the financial health of companies with no debt.
See our latest analysis for Kina Petroleum
Does KPL’s growth rate justify its decision for financial flexibility over lower cost of capital?
Debt funding can be cheaper than issuing new equity due to lower interest cost on debt. Though, the trade-offs are that lenders require stricter capital management requirements, in addition to having a higher claim on company assets relative to shareholders. The lack of debt on KPL’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 KPL is a high-growth company. KPL delivered a negative revenue growth of -94%. 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.
Can KPL pay its short-term liabilities?
Since Kina Petroleum 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 US$1m, it seems that the business has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 5.41x. However, anything above 3x may be considered excessive by some investors.
Next Steps:
KPL 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 KPL’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, KPL’s financial situation may change. This is only a rough assessment of financial health, and I’m sure KPL has company-specific issues impacting its capital structure decisions. I recommend you continue to research Kina Petroleum to get a more holistic view of the stock by looking at: