Taking on too much debt may sound like a bad thing, but that's not always the case. Sometimes, debt-laden companies can provide solid returns. Caterpillar
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 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 Caterpillar and compare it with its peers.
Source: S&P Capital IQ.
Caterpillar's debt-to-equity ratio stands at a pretty high 258.2%. The world's largest construction-equipment maker's debt in the last 12 months has risen by 22% to $34.5 billion. The debt may look high, but that's hardly surprising considering the capital-intensive industry that Cat operates in. However, with a very healthy interest coverage ratio of 18.1, the company is bringing in revenue to cover its interest payments. Add to that a free cash flow of $3.5 billion and a current ratio of 1.3, and you'll see that there is enough cushion.
Peer Manitowoc's debt-to equity is almost one-and-a-half times that of Cat's. Further, its interest coverage ratio of 1.4 could make investors a little uneasy. Terex and Joy Global are both significantly less leveraged than Cat and Manitowoc, and Joy seems to have the strongest overall balance sheet when it comes to debt exposure. While these firms must invest in capital, expand into new markets, and finance their daily operations, it's important to keep an eye on these metrics and how they move over time to gauge management's performance.
Looking at Cat, in particular, the company is expanding in earnest globally, especially in emerging markets. These markets provide great construction as well as mining opportunities. We all know that Cat is expanding heavily in the BRIC nations, especially in China. After the acquisition of Bucyrus last year, Cat has also increased its presence in the mining space. In fact, its product range is now even larger than that of its closest adversary, Joy Global.
Caterpillar, with a strong global reach, looks very well-positioned. And with earnings slated to come out tomorrow, this is one stock I would keep a close eye on. You can do so with the help of the Fool's free My Watchlist service.
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Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of Joy Global. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.