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 and can thus result 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 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 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 retailer Macy's
|Macy's||130.8 %||5.4 times||1.4 times|
||31.1 %||3.3 times||2.7 times|
||77.5 %||2.2 times||1.8 times|
||65.2 %||7.2 times||1.8 times|
Source: S&P Capital IQ.
Compared to its peers, Macy's debt-to-equity ratio stands at a higher 130.8%. The company's debt has risen in the past 12 months to $7.7 billion but is still lower than its average of the past few years. With an interest coverage ratio of 5.4 times, it is at the high end of the industry. Macy's is bringing in enough revenue to comfortably cover its interest requirements. There is not much to worry about, really.
By comparison, Saks looks less leveraged but also has a less robust interest coverage ratio, ditto for J.C. Penney. Kohl's is looking pretty robust with a low debt-to-equity ratio and a very high interest coverage ratio.
Macy's repaid about $454 million in debt last fiscal year after repaying $1.24 billion in fiscal 2010. The company issued $800 million in debt in the fourth quarter of last year, but it plans to repay about $790 million in the first half of 2012. What is heartening is that the company has pretty strong cash flows with the trailing figure at $1.88 billion.
It's putting the cash to good use, too, and is looking to return value to its shareholders through share repurchases. Last year it spent $500 million in buying back 16.4 million shares. It still has $1.352 billion left on its current repurchase authorization.
I wouldn't really worry about Macy's debt. The company came off a really strong quarter where it saw its profits soar 12% helped by what was a "terrific holiday selling season." It has made great inroads with its online business through its offerings at Macys.com and Bloomingdales.com. Last quarter, sales were up 40%. The online business has helped Macy's since it boosted sales and helped the retailer manage its inventory much better, too. In addition, a shift to omnichannel integration of stores, which brings together the Internet and the mobile technologies, has also helped the company perform well.
Macy's has put up a good performance on all fronts and should continue to do so going ahead. To stay up to date on Macy's, simply add the stock to your watchlist. It's free; click here to start using the service now.
Fool contributor 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.