Taking on too much debt may sound like a bad thing, but it's not always. Sometimes, debt-laden companies can provide solid returns. Let's see how.
Generally, the cost of raising debt is cheaper than the cost of raising equity. Raising debt against equity has two observable consequences -- first, the equity that shareholders value doesn't get diluted, and second, it results in a higher interest expense. As interest is charged before tax, a higher interest rate provides a tax shield, thus resulting in higher profits. Higher profits coupled with a lower share count translates into higher earnings per share.
However, when assuming debt, a company should see whether the returns from investing the money are higher than the cost of the debt itself. If not, the company is headed for some serious trouble.
It's prudent for investors to see whether a company is strongly positioned to handle the debt it has taken on -- i.e. comfortably meet its short-term liabilities and interest payments. Let's look at two simple metrics to help us understand debt positions.
- The debt-to-equity ratio tells us what fraction of the debt as opposed to equity a company uses to help fund its assets.
- The interest coverage ratio is a way of measuring how easily a company can pay off the interest expenses on its outstanding debt.
- The current ratio tells us what proportion of a company's short-term assets are available to finance its short-term liabilities.
And now let's examine the debt situation at Ford (NYSE: F ) and compare it with its peers.
|General Motors (NYSE: GM )
|Toyota (NYSE: TM )
|Honda (NYSE: HMC )
Source: S&P Capital IQ.
Ford has a staggeringly high debt-to-equity ratio. High debt is common among automakers, though it's worth noting that the company has reduced its debt over the past 12 months to $98 billion from $117.3 billion.
Ford's total automotive debt -- the debt that isn't part of its credit operations and assumed from its core automotive business -- stood at $16.6 billion as of March 31. It plans to reduce this figure to around $10 billion by 2015, even as it aggressively expands its operations around the globe. It helps that Ford has a high free cash flow of $7.1 billion, so it shouldn't encounter too many difficulties in paying off its debt. And with a comfortable interest coverage ratio of 7.2, Ford is in a fairly comfortable position to pay off its debt-related interest expenses.
As for those expansion plans, electric vehicles have come more and more into the limelight, and Ford accordingly plans to increase its electric-vehicle production threefold by 2013. And as fellow Fool Neha Chamaria pointed out, Ford's geographic expansion has been focused largely on the emerging markets of China and India. These efforts should help Ford continue to bring in the green.
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