Zero-debt allows substantial financial flexibility, especially for small-cap companies like Design Hotels AG (FRA:LBA), 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. While LBA has no debt on its balance sheet, it doesn’t necessarily mean it exhibits financial strength. I will take you through a few basic checks to assess the financial health of companies with no debt.
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Is financial flexibility worth the lower cost of capital?
Debt capital generally has lower cost of capital compared to equity funding. 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 LBA’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 LBA is a high-growth company. A single-digit revenue growth of 5.0% for LBA is considerably 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.
Can LBA meet its short-term obligations with the cash in hand?
Given zero long-term debt on its balance sheet, Design Hotels 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 €5.7m, it seems that the business has maintained a safe level of current assets to meet its obligations, with the current ratio last standing at 2.79x. Usually, for Media companies, this is a suitable ratio since there is a bit of a cash buffer without leaving too much capital in a low-return environment.
LBA 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 LBA’s liquidity needs, this may be its optimal capital structure for the time being. Going forward, its financial position may change. Keep in mind I haven’t considered other factors such as how LBA has been performing in the past. I recommend you continue to research Design Hotels to get a more holistic view of the stock by looking at:
- Future Outlook: What are well-informed industry analysts predicting for LBA’s future growth? Take a look at our free research report of analyst consensus for LBA’s outlook.
- Valuation: What is LBA worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether LBA is currently mispriced by the market.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.