Taking on lots of debt isn't always a bad thing. 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. Can it meet its short-term liabilities and interest payments? Let's look at three 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 portion of a company's short-term assets is available to finance its short-term liabilities.
Let's examine the debt situation at Kinder Morgan Energy Partners
|Kinder Morgan Energy Partners||176.3%||3.2 times||0.5 times|
Magellan Midstream Partners
||145.9%||4.7 times||2.0 times|
Enterprise Products Partners
||133.3%||3.4 times||0.8 times|
||101.4%||3.4 times||1.2 times|
Source: S&P Capital IQ.
Compared to its peers, Kinder Morgan has a high debt-equity ratio of 176.3%. The company plans to expand operations to increase natural gas output. It recently acquired 50% of a natural gas gathering system with Petrohawk, and also the Fayetteville Express pipeline. These acquisitions helped drive up revenues in its latest quarter.
Kinder Morgan's current ratio doesn't make for good reading and is well below its peers'. However, the company has a decent interest coverage ratio of 3.2 times, which means that it is bringing in enough green to comfortably pay off its interest expenses. Also, I expect the company's current expansion plans to reap benefits going ahead. Thus, the low current ratio should not be a worry.
To add to this, Kinder Morgan Energy's parent, Kinder Morgan
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Shubh Datta doesn't own any shares in the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Enterprise Products Partners and Magellan Midstream Partners. 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.