Taking on too much debt may sound like a bad thing, and it certainly was for many companies in the previous recession. But things don't always result in disaster when it comes to leverage, and 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 we as shareholders value so much doesn't get diluted because debtors don't have any claim on a company's residual profits., Second, it results in a higher interest expense. Given that interest is charged before tax, a higher interest rate provides a tax shield, thus providing another means to juice profits. Higher profits coupled with a lower to stable share count translate into higher earnings per share.
However, when assuming debt, a company should be confident that the returns from investing this money are high enough to merit the enhanced risk and interest burden of debt financing. If not, the company could be 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.
With that in mind, let's examine the debt situation at Sirius XM Radio
|Sirius XM Radio||348%||2.3||0.60|
Source: S&P Capital IQ.
Sirius XM has a debt-to-equity ratio of 348%, which is just about half of uber-leveraged Cumulus Media's ratio. Sirius' debt in the past 12 months has hovered around the $3 billion mark. The satellite-radio provider's interest coverage ratio of 2.3 indicates that it's profitable enough to pay off its ongoing interest requirements. The company's current ratio of 0.6 might look low relative to its peers' average of about 1.8, but that difference can be chalked up to business model differences -- in particular, the accounting treatment of subscription payments from customers.
The company ended its first quarter with a strong free cash flow of $15 million, as opposed to the negative $17 million it had reported a year ago. Interestingly, this is the first time Sirius has ever reported a positive free cash flow in the first quarter of the year. Based on the figures we've looked at, it appears as though Sirius shouldn't really have any problems in servicing its near-term debt requirements. However, with a number of debt maturities coming up in 2012 and 2013, it will be important to keep an eye on these metrics.
Turning to its peers, Cumulus has the highest leverage ratio of the bunch. But an interest coverage ratio of 1.4 and a current ratio of 2.1 indicate that Cumulus is bringing in just about enough to fend for its short-term requirements. While Cumulus operates with a small margin for error, Saga and CBS are the least leveraged of the lot, and both have very healthy interest coverage ratios to show for it.
Coming back to Sirius, it's fresh off a strong quarter, where it saw its earnings rise by an impressive 38%. The quarter also saw it add a further 405,000 subscribers to its base. One thing to note is that the radio provider raised its base monthly rate back in January to $14.49, a 12% increase. Most observers wondered how subscribers would react. I'd say they took it well, as the company also upped its net additions target to 1.5 million from its prior target of 1.3 million subscribers.
There's another thing to note about why Sirius upped its subscriber guidance. Earlier this year, auto analysts were expecting annual car sales of 13.7 million but have revised those estimates to 14.3 million. The interesting thing to consider is that almost two-thirds of the cars up for sale come with pre-installed Sirius or XM receivers. Thus, with the bump in auto analysts' estimates accounting for the lion's share of the guidance improvement, any additional operational improvements could translate to stronger subscriber growth -- a welcome sign for Sirius. This alone makes the satellite-radio provider one I'll be watching out for. You can keep track of Sirius, too, with the help of our free Watchlist service.
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Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool has a disclosure policy.We Fools don't 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.