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The direct benefit for Rane Brake Lining Limited (NSE:RBL), 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 RBL 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.
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Does RBL’s growth rate justify its decision for financial flexibility over lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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 RBL’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 RBL is a high-growth company. RBL’s revenue growth over the past year is a single-digit 7.9% 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.
Does RBL’s liquid assets cover its short-term commitments?
Given zero long-term debt on its balance sheet, Rane Brake Lining 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. At the current liabilities level of ₹1.2b liabilities, the company has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 1.53x. For Auto Components companies, this ratio is within a sensible range as there’s enough of a cash buffer without holding too much capital in low return investments.
Next Steps:
As a high-growth company, it may be beneficial for RBL to have some financial flexibility, hence zero-debt. Since there is also no concerns around RBL’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, its financial position may be different. Keep in mind I haven’t considered other factors such as how RBL has been performing in the past. You should continue to research Rane Brake Lining to get a more holistic view of the stock by looking at: