One potential risk that all investors should pay attention to is the level of debt held by the companies that they are invested in. This is because paying debt is a fixed commitment. Unlike stock buyback programs or dividend payments, a company can't arbitrarily reduce the amount it pays toward debt if its business slows down and causes its free cash flow to decline.
Of course, we can't just compare the debt levels of two companies of dramatically different sizes directly because a much larger company will have much more money coming in to cover this debt. Instead, we need to use measures such as the debt-to-equity ratio.
The debt-to-equity ratio is a method of comparing the relative debt levels of two companies of different sizes on an equal footing. Because a company doesn't have to guarantee a return on its equity the way it does on its debt, equity is often considered to be a much safer way for a company to raise money.
To illustrate this concept and examine how it can be a risk, let's take a look at the debt-to-equity ratios of several offshore drilling companies. The five companies that we will compare are Seadrill (NYSE:SDRL), Transocean (NYSE:RIG), Ensco (NYSE:ESV), Noble, and Diamond Offshore.
|Company Name||Total Debt||Total Equity||Debt-to-Equity Ratio|
|Seadrill||$14.9 billion||$8.2 billion||1.82|
|Transocean||$10.5 billion||$17.2 billion||0.61|
|Ensco||$4.8 billion||$12.9 billion||0.37|
|Noble||$4.4 billion||$7.5 billion||0.59|
|Diamond Offshore||$2.5 billion||$4.6 billion||0.54|
As the chart shows, Ensco has a substantially lower amount of debt relative to its equity than its peer companies do. Meanwhile, Seadrill stands out as having a substantially higher level of debt than its peers. This shows us that the two companies have very different risk profiles.
Exposure to revenue downturns
Seadrill would be much more affected by a downturn in the industry that causes the company's free cash flow to decline than Ensco would. This is because Seadrill has to pay a fixed amount to maintain this debt load (as does Ensco); if a downturn causes its revenues to decline too much, the company could run into financial trouble as it would be unable to afford its interest payments. Ensco also has this same risk, but its earnings would need to decline much further before it runs into trouble.
Rolling over debt
Another potential risk could present itself when it comes to rolling over debt. This is due to the fact that all debt eventually matures, at which point the indebted company must either pay off the loan with cash or take out another loan to pay off the first one. This second option is called "rolling over debt."
The risk has to do with the fact that there are times, particularly when an industry or company is particularly weak, that it may be difficult to get a new loan. If the company doesn't have the money to pay off the loan at that time then it may be forced to resort to other methods of generating cash, including selling off assets. In the case of an offshore drilling company, this could mean selling off income-producing assets such as drilling rigs. This would have an adverse impact on future earnings. If the company can't do this then it would likely be forced into financial insolvency; this typically causes a company's share price to plunge dramatically.
Benefits of leverage
Like anything in finance, there is a risk/reward trade-off associated with the use of leverage. Seadrill, for example, can offer some benefits to investors that a less levered company like Ensco cannot. Foremost among these is faster per-share growth. By using debt to obtain the money to grow instead of issuing stock, Seadrill can ensure that the higher earnings that this growth results in is spread around the same number of shares. This benefits stockholders who may see a higher return than with a company that uses more conservative financing such as Ensco.
In conclusion, it is important to understand both the risks and benefits of high leverage when determining whether an investment is right for you. A highly leveraged company can typically generate more rapid earnings and cash flow growth on a per-share basis, but it is also a strategy that exposes the company to higher risk in the case of a downturn. In the end, we all need to determine what is the right investment for us.
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Daniel Gibbs has a long position in Seadrill. His research firm, Powerhedge LLC, has a business relationship with a registered investment advisor whose clients may hold positions in any of the stocks mentioned. Powerhedge LLC has no positions in any stocks mentioned and is not a registered investment advisor. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.