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 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 ATP Oil & Gas
|ATP Oil & Gas||647.1%||0.2 times||0.5 times|
||50.9%||18.0 times||1.1 times|
Plains Exploration & Production
||107.6%||4.1 times||0.7 times|
Stone Energy Corp
||86.6%||29.1 times||1.4 times|
Source: S&P Capital IQ.
ATP Oil & Gas' debt-to-equity ratio when compared with that of its peers is at a staggeringly high 647.1%. The company's debt in the past 12 months has risen to $2 billion, from $1.7 billion. ATP has acquired a lot of properties after winning three deepwater licenses in the Mediterranean Sea area back in June. It plans to spend $70 million to $120 million in what's left of 2011, after expending $400 million in the first nine months of the year. This is fine, but the problem is that nearly 81% of its proved reserves are yet to be developed.
The main concern is that ATP has been through quite a torrid time of late. In the past six quarters, it has suffered five consecutive losses and in its most-recent quarter, it recorded a lowly profit of $1.1 million. The poor earnings show has resulted in such a low interest coverage ratio and negative retained earnings of $526.6 million. The company is currently not bringing in enough to cover its interest expenses. Unless ATP manages to turn around its numbers, it will be difficult for the company to reduce its indebtedness.
Shubh Datta doesn't own any shares in the companies mentioned above. 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.