Phylogica Limited (ASX:PYC), which has zero-debt on its balance sheet, can maximize capital returns by increasing debt due to its lower cost of capital. However, the trade-off is PYC will have to follow strict debt obligations which will reduce its 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 PYC’s financial health. View our latest analysis for Phylogica

Is financial flexibility worth the lower cost of capital?

Debt capital generally has lower cost of capital compared to equity funding. 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 PYC 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. PYC delivered a strikingly high triple-digit revenue growth over the past year, therefore the company’s decision to choose financial flexibility is justified as it may need headroom to borrow in the future to sustain high growth.

Does PYC’s liquid assets cover its short-term commitments?

Since Phylogica 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. With current liabilities at AU$1.49M, it appears that the company has been able to meet these obligations given the level of current assets of AU$10.13M, with a current ratio of 6.8x. However, anything above 3x is considered high and could mean that PYC has too much idle capital in low-earning investments.

Next Steps:

PYC is a fast-growing firm, which supports having have zero-debt and financial freedom to continue to ramp up growth. This may mean this is an optimal capital structure for the business, given that it is also meeting its short-term commitment. In the future, its financial position may change. I admit this is a fairly basic analysis for PYC’s financial health. Other important fundamentals need to be considered alongside. I recommend you continue to research Phylogica to get a more holistic view of the stock by looking at: