The direct benefit for Lung Kee (Bermuda) Holdings Limited (HKG:255), 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 255 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.

See our latest analysis for Lung Kee (Bermuda) Holdings

Is financial flexibility worth the 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 255’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 255 is a high-growth company. A revenue growth in the teens is not considered high-growth. 255’s revenue growth of 14% falls into this range. More capital can help the business grow faster. If 255 is not expecting exceptional future growth, then the decision to avoid may cost shareholders in the long term.

Can 255 meet its short-term obligations with the cash in hand?

Given zero long-term debt on its balance sheet, Lung Kee (Bermuda) Holdings has no solvency issues, which is 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. Looking at 255’s most recent HK$333m liabilities, it seems that the business has been able to meet these obligations given the level of current assets of HK$1.6b, with a current ratio of 4.72x. Having said that, many consider anything above 3x to be quite high and could mean that 255 has too much idle capital in low-earning investments.

Next Steps:

255 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. Moving forward, its financial position may change. This is only a rough assessment of financial health, and I’m sure 255 has company-specific issues impacting its capital structure decisions. You should continue to research Lung Kee (Bermuda) Holdings to get a better picture of the stock by looking at:

1. Future Outlook: What are well-informed industry analysts predicting for 255’s future growth? Take a look at our free research report of analyst consensus for 255’s outlook.

2. Valuation: What is 255 worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether 255 is currently mispriced by the market.

3. 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.