Prana Biotechnology Limited (ASX:PBT), 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 PBT 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.
Check out our latest analysis for Prana Biotechnology
Is PBT growing fast enough to value 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. PBT’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. PBT’s revenue growth over the past year is a single-digit 5.4% which is relatively low for a small-cap company. While its low growth hardly justifies opting for zero-debt, the company may have high growth projects in the pipeline to justify the trade-off.
Can PBT pay its short-term liabilities?
Since Prana Biotechnology 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. But another important aspect of financial health is liquidity: the company’s ability to meet short-term obligations, including payments to suppliers and employees. With current liabilities at AU$3m, it seems that the business has been able to meet these obligations given the level of current assets of AU$19m, with a current ratio of 7.06x. However, a ratio greater than 3x may be considered as quite high, and some might argue PBT could be holding too much capital in a low-return investment environment.
Next Steps:
Having no debt on the books means PBT has more financial freedom to keep growing at its current fast rate. 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, PBT’s financial situation may change. Keep in mind I haven’t considered other factors such as how PBT has been performing in the past. I recommend you continue to research Prana Biotechnology to get a more holistic view of the stock by looking at: