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.
Let's look at the debt situation at Limited Brands
||43.4%||2.5 times||2.2 times|
Source: S&P Capital IQ.
Limited has a remarkably high debt-to-equity ratio of 577.1%. Over the past 12 months, its debt has risen to $3.6 billion from $2.6 billion. At the same time, equity has fallen to $625 million from $2.07 billion a year ago. In 2010, Limited paid out more than $1.5 billion to its investors in the form of dividends and share repurchases, resulting in lower outstanding equity.
Limited, which operates such brands as Victoria's Secret and Bath & Body Works, saw a staggering 30% jump in profits this quarter over last. Though the company has used up a sizeable amount of cash to pay out dividends and fund buybacks, a free cash flow of $997 million suggests that it still has a large amount of money left in its coffers. Limited's interest-coverage ratio and current ratio indicate that it should have no real problems paying off its short-term interest requirements and liabilities.
Limited has been looking to expand internationally and plans to operate close to 1,000 stores internationally by the end of 2011. If Limited can deliver on its growth and continue to capitalize on its strong performance, it should have no real problem paying off its debts.
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Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of Gap and Limited Brands. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.