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 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 able to 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.
And now let's examine the debt situation at Delta Air Lines
|Delta Air Lines||1,195.8%||1.6 times||0.6 time|
US Airways Group
||2,811.9%||1.4 times||1.0 time|
||64.9%||5.0 times||0.9 time|
United Continental Holdings
||569.1%||2.6 times||1.0 time|
||179.1%||1.8 times||1.2 times|
Source: S&P Capital IQ.
Delta's debt-to-equity ratio of 1,195.8% looks staggeringly high compared to its peers, with the exception of US Airways. In the last nine months, Delta's debt has fallen to $14.6 billion from $15.3 billion, though the current figure is still quite high, even after Delta exited bankruptcy. Though Delta's current ratio is lower than its peers', its interest coverage ratio of 1.6 times indicates that it is currently generating enough revenue to pay off its interest requirements. It has also been registering profits recently, with the bottom line in its most recent quarter increasing by a solid 51% from a year ago.
The airline industry, after quite a rough flight this year, may be on the rebound. Many airliners are planning to overhaul their fleet as they look to switch to more fuel-efficient narrow-bodied carriers. Back in August, Delta agreed to buy 100 Boeing 737s. We'll have to wait and see what effect AMR's bankruptcy has on Delta and the industry. We'll certainly be watching.
Fool contributor Shubh Datta doesn't own any shares of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. 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.