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. Since interest is charged before tax, a higher interest rate provides a tax shield of sorts and can result in higher profits. Higher profits coupled with a lower share count translate 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 Campbell Soup (NYSE: CPB ) and compare it with its peers.
|H.J. Heinz (NYSE: HNZ )||166.7%||5.7||N/A|
|General Mills (NYSE: GIS )||92.5%||7.0||1.0|
Source: S&P Capital IQ.
Campbell's has the highest debt-to-equity ratio of the lot with a figure of 216.7%. The company's total debt stands at $2.7 billion, which is down from $3.2 billion in the year-ago period. When it comes to handling debt, the company has a solid interest coverage ratio of 10.7, the highest of the lot, which indicates that the company is bringing in enough revenues to cover for its short-term interest requirements. To add to that, its current ratio of 0.9 is in line with that of its peers. So I don't really see the company having any trouble in managing its debt burden.
Turning to its peers, Heinz is the second-most leveraged food maker of the group, with a debt-to-equity ratio of 166.7. It has a healthy interest coverage ratio to show for it as well. General Mills, the maker of Progresso soup, is the least leveraged of the group and it, too, has a healthy interest coverage ratio.
Coming back to Campbell's, the soup maker recently saw its third-quarter profits fall by 5% as it was difficult to find a balance between rising commodity costs and sluggish soup sales. CEO Denise Morrison is trying hard to revive the company's sales and is banking on brand expansion strategies and more innovative products to do the trick. And she's also hoping that a more consumer-centric approach will help as well. These strategies may help revive the company's sales, but it'll also have to be watchful of the cautious nature of consumers.
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