Zero-debt allows substantial financial flexibility, especially for small-cap companies like Red Emperor Resources NL (ASX:RMP), as the company does not have to adhere to strict debt covenants. However, it also faces higher cost of capital given interest cost is generally lower than equity. Zero-debt can alleviate some risk associated with the company meeting debt obligations, but this doesn’t automatically mean RMP has outstanding financial strength. I recommend you look at the following hurdles to assess RMP’s financial health.
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Is financial flexibility worth the 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. The lack of debt on RMP’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 RMP is a high-growth company. Opposite to the high growth we were expecting, RMP’s negative revenue growth of -15% hardly justifies opting for zero-debt. If the decline sustains, it may find it hard to raise debt at an acceptable cost.
Does RMP’s liquid assets cover its short-term commitments?
Since Red Emperor 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. 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 RMP’s most recent AU$133k liabilities, it appears that the company has been able to meet these obligations given the level of current assets of AU$10m, with a current ratio of 78.17x. However, a ratio greater than 3x may be considered as quite high.
Next Steps:
RMP is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. Since there is also no concerns around RMP’s liquidity needs, this may be its optimal capital structure for the time being. Moving forward, RMP’s financial situation may change. This is only a rough assessment of financial health, and I’m sure RMP has company-specific issues impacting its capital structure decisions. I suggest you continue to research Red Emperor Resources to get a better picture of the stock by looking at: