Things Don't Look Good at Frontline

Taking on too much debt may sound like a bad thing, but it's not always the case. 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 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 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 is available to finance its short-term liabilities.

Now let's examine the debt situation at Frontline (NYSE: FRO) and compare it with its peers.

Source: S&P Capital IQ. NM = not meaningful; interest coverage was not computed for NAT because the company has negative operating income.

Compared to its competitors, Frontline has a much higher debt-to-equity ratio. Although the company has reduced its total debt to $2.7 billion from $2.9 billion a year ago, the industry as a whole isn't going through the best of times. The oil tanker business has struggled because of falling imports and excess supply.

Frontline's interest coverage ratio of 0.7 times means that the company is not currently generating enough revenue to satisfy its interest expenses, though a current ratio of 1.3 times implies that Frontline may have some time to turn that trend around.

The main thing is that the future doesn't look that bright for the biggest operator of supertankers at the moment. Supertankers traveling on the industry benchmark Saudi Arabia to Japan course will not be able to earn more than $13,818 a day till the end of 2013 because of annual forward freight agreements. To break even, Frontline would require at least $29,800 a day. To keep a closer eye on the workings of Frontline, click here to add it to your watchlist.