The direct benefit for Prospect Resources Limited (ASX:PSC), 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 PSC 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 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 Prospect Resources

Does PSC’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. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. PSC’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. PSC’s revenue growth over the past year was an impressively high triple-digit rate, so it is acceptable that the company is opting for a zero-debt capital structure currently as it may need to raise debt to fuel expansion in the future.

Can PSC pay its short-term liabilities?

Given zero long-term debt on its balance sheet, Prospect Resources has no solvency issues, which is 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$1.5m, the company has been able to meet these commitments with a current assets level of AU$17m, leading to a 11.79x current account ratio. Having said that, a ratio above 3x may be considered excessive by some investors.

Next Steps:

Having no debt on the books means PSC has more financial freedom to keep growing at its current fast rate. Since there is also no concerns around PSC’s liquidity needs, this may be its optimal capital structure for the time being. In the future, PSC’s financial situation may change. Keep in mind I haven’t considered other factors such as how PSC has been performing in the past. I suggest you continue to research Prospect Resources to get a better picture of the stock by looking at: