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.
The cost of raising debt can be cheaper than the cost of raising equity. Raising debt against equity has observable consequences -- the most important being paying an interest expense. However there are positives to raising debt instead of raising equity, for example interest is charged before tax, meaning the interest rate provides a tax shield, lowering the amount of tax paid, which can result in greater cash flows. Higher cash flows coupled with a lower share count; using debt as the funding instrument 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 three 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 is available to finance its short-term liabilities.
And now let's examine the debt situation at Frontline (NYSE: FRO ) and compare it with its peers.
Source: S&P Capital IQ.
Compared to its competitors, Frontline's debt-to-equity is much higher -- more than three times that of its closest competitor, Ship Finance (NYSE: SFL ) . The company, however, has managed to reduce its debt to $1.5 billion from $2.8 billion 12 months ago as the company restructured its business in December, which included the selling off of six VLCCs and four Suezmax tankers and also five VLCC newbuild contracts to Frontline 2012, a spinoff of Frontline. Frontline 2012 also absorbed $666.3 million worth of bank debt from its parent company.
The problem is that the company is just not bringing in enough revenues to cover its interest payments, as its interest coverage ratio of 0.2 suggests. However, a current ratio of 2.5 gives the company time to turn that trend around.
Peers Ship Finance and Genco (NYSE: GNK ) are both less leveraged than Frontline. Interest coverage ratios of 1.5 and 1.3, respectively, suggest that both are bringing in enough revenues to cover their interest requirements.
Coming back to Frontline, things aren't looking great, especially as the company has reported losses in four of its last five quarters. Much of the losses came from the fact that the shipping industry has been shrouded by low demand, excess supply, and low spot rates. Recently, though, Frontline was given a lift by a report suggesting demand from oil tankers was recovering and that oil shipments to China had risen dramatically. This quarter, Suezmaxes are slated to earn $18,750 a day, which is higher than the $16,400 that Frontline requires to break even. So things may be looking up for Frontline after all. To see how things work out for Frontline, click here to add it to your watchlist and stay up to date.
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