Taking on too much debt may sound like a bad thing to you, but that is not always the case. Debt-laden companies can actually 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 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 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. Or else, the company is headed for some serious trouble.
As an investor, it's prudent to see whether a company is strongly positioned to ably handle the debt it has taken on, i.e., comfortably meet its short-term liabilities and interest payments. Hopefully, this article will help shed some light in this regard. To do so, let's take a look at two simple metrics that help us understand the debt position of a company.
The debt-to-equity ratio tells us what fraction of the debt as opposed to equity a company uses to help fund for its assets.
The interest coverage ratio is an easy way of measuring how efficiently 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 it to finance its short-term liabilities.
Let us now take a look at the debt situation of midstream services provider Enterprise Products Partners
|Enterprise||122.3%||4.5 times||0.8 time|
||173.1%||2.7 times||0.8 time|
||102.9%||6.9 times||1.2 times|
||37.0%||17.2 times||2.0 times|
||89.0%||3.9 times||0.3 time|
Source: S&P Capital IQ.
Enterprise has a very high debt-to-equity ratio of 122.3%, second only to El Paso. Enterprise's debt has significantly increased to $14.39 billion from $12.72 billion in the last 12 months as it has been looking to boost its operations. It is planning to expand its operations in the Eagle Ford shale play and has entered into deals with EOG Resources
A few months ago it also announced plans to expand its operations in the Rocky Mountains segment of its Mid-American Pipeline system to help transport natural gas more efficiently. That partly explains why the company has such a high level of debt on its books.
Assuming debt to expand operations is one thing, but paying it off is another. Enterprise has a free cash flow of $272.6 million, which dropped from $859.0 million a year ago as the company increased its capital expenditure in the last 12 months and repaid some debt.
But it does appear comfortably positioned to pay off its interest requirements, as indicated by an interest coverage ratio of 4.5 times. However, with a current ratio of 0.8, the company is not the best from a liquidity viewpoint and may find it a little difficult to pay off its noninterest-bearing obligations through its short-term assets at present. But it doesn't ring a warning bell yet, as the company's expansion plans should help the company generate cash and thus also help push up its current ratio.
With natural gas consumption expected to increase 14% by 2035, Enterprise's expansion efforts should put it in a good place to take advantage of this increase in demand and also help the company generate more cash.
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Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of Devon Energy. Motley Fool newsletter services have recommended buying shares of Enterprise Products Partners and Chesapeake Energy. 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.