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The direct benefit for Krakatoa Resources Limited (ASX:KTA), 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 KTA 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 recommend you look at the following hurdles to assess KTA’s financial health.
Check out our latest analysis for Krakatoa Resources
Does KTA’s growth rate justify its decision for financial flexibility over 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. Either KTA does not have access to cheap capital, or it may believe this trade-off is not worth it. This makes sense only if the company has a competitive edge and is growing fast off its equity capital.
Does KTA’s liquid assets cover its short-term commitments?
Since Krakatoa Resources 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 AU$67.4k, it appears that the company has been able to meet these obligations given the level of current assets of AU$697.7k, with a current ratio of 10.34x. Having said that, anything above 3x may be considered excessive by some investors. They might argue KTA is leaving too much capital in low-earning investments.
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Having no debt on the books means KTA has more financial freedom to keep growing at its current fast rate. Since there is also no concerns around KTA’s liquidity needs, this may be its optimal capital structure for the time being. Going forward, its financial position may change. Keep in mind I haven’t considered other factors such as how KTA has been performing in the past. You should continue to research Krakatoa Resources to get a better picture of the stock by looking at:
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Historical Performance: What has KTA’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.
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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.