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 SUPERVALU
Source: S&P Capital IQ.
The company has a debt-equity ratio of 493.1%, which, compared with its peers, is pretty high. But an interest-coverage ratio of 1.8 implies that SUPERVALU can pay off its short-term interest requirements. And with a current ratio of 0.9, SUPERVALU is fairly well placed to pay off its short-term liabilities and is right in line with its industry peers.
Fellow Fool Jim Royal recently highlighted the fact that the company is undergoing a turnaround as new CEO Craig Herkert takes over the reins. It's looking to improve the way SUPERVALU's products are perceived as well as expanding its Save-A-Lot stores going ahead. Plus, in an effort to raise more capital, SUPERVALU is planning to sell 107 of its fuel centers.
SUPERVALU took on a hefty chunk of debt when it acquired Albertsons back in 2006. Jim mentions that since 2008 the grocer has paid off nearly $1.8 billion of its debt. Although it still has $7 billion worth of debt in its books, just $1 billion of it will be payable in the next three years, so it should have enough time to sort out its debt situation.
To keep a close eye on SUPERVALU's progress and how it tackles its debt, add it to My Watchlist.