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Zero-debt allows substantial financial flexibility, especially for small-cap companies like Sovereign Metals Limited (ASX:SVM), 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 SVM has outstanding financial strength. I recommend you look at the following hurdles to assess SVM’s financial health.
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Is SVM right in choosing financial flexibility over lower cost of capital?
There are well-known benefits of including debt in capital structure, primarily a lower cost of capital. However, the trade-off is debtholders’ higher claim on company assets in the event of liquidation and stringent obligations around capital management. The lack of debt on SVM’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 SVM is a high-growth company. SVM’s revenue growth over the past year is a double-digit 36% which is considerably high for a small-cap company. 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 SVM meet its short-term obligations with the cash in hand?
Since Sovereign Metals 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 SVM’s AU$1.1m in current liabilities, it appears that the company has been able to meet these commitments with a current assets level of AU$4.0m, leading to a 3.8x current account ratio. However, a ratio above 3x may be considered excessive by some investors.
Next Steps:
As a high-growth company, it may be beneficial for SVM to have some financial flexibility, hence zero-debt. Since there is also no concerns around SVM’s liquidity needs, this may be its optimal capital structure for the time being. In the future, its financial position may be different. This is only a rough assessment of financial health, and I’m sure SVM has company-specific issues impacting its capital structure decisions. You should continue to research Sovereign Metals to get a more holistic view of the stock by looking at: