Taking on too much debt may sound like a bad thing, but it's not always. Sometimes, debt-laden companies can provide solid returns.
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., able to 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 Medco Health Solutions
|Medco||141.9%||12.5 times||0.7 times|
||42.8%||17.3 times||0.8 times|
||16.2%||53.3 times||1.5 times|
||28.7%||10.7 times||1.5 times|
Source: S&P Capital IQ.
Medco's debt-to-equity ratio stands at a high 141.9%. However, the company's debt remains more or less unchanged from a year ago at around $5 billion. It has a good interest coverage ratio of 12.5, which means it can comfortable service its short-term interest requirements.
Though the company's current ratio is on the lower side, this shouldn't really be a problem. Medco has consistently generated plenty of free cash flow, which in the past 12 months has amounted to nearly $1.8 billion. The thing to note here is that Medco is poised to become the largest pharmacy benefits manager (PBM) in the United States. It's looking to join forces with fellow PBM Express Scripts
Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of UnitedHealth Group. Motley Fool newsletter services have recommended buying shares of Medco Health Solutions and UnitedHealth Group and creating a diagonal call position in UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.
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