Taking on debt may sound like a bad thing, but it's not always the red flag it's made out to be. 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 of sorts.
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., it can 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 SUPERVALU
Source: S&P Capital IQ.
Grocer SUPERVALU is the most leveraged of the group, with a huge debt-to-equity ratio of 29,790.48%. The low equity, a meager $21 million, stems from the fact that the company has negative retained earnings on its books.
SUPERVALU has a total debt of $6.3 billion -- nearly six times its market cap of $1.02 billion. The company took on a sizable chunk of debt when it acquired Albertsons way back in 2006. Still, I'm not worried, as it has time on its hands to manage its debt.
The reason I'm saying this debt is manageable is because most of it is due after 2016. Keeping that in mind, SUPERVALU has an interest coverage ratio of 1.83, which implies that the company is bringing in enough revenue to cover its short-term interest requirements. Plus, its interest coverage ratio of 0.9 times is well in line with that of its industry peers. No red flags there. To top it all off, the company has been diligently paying down its debt since the acquisition -- something that will only get easier as it pays down more.
Turning to its peers, Kroger and Safeway are less leveraged than SUPERVALU, and both have healthy interest coverage ratios to show for it. Wal-Mart is the least leveraged of the lot and also has the highest interest coverage ratio at 11.59. SUPERVALU'S competitors are well-prepared to pay their short-term interest requirements.
What we should also remember is that the company is in a turnaround phase under CEO Craig Herkert, and much of the losses are attributable to goodwill and intangible-asset impairment charges.
This is a dividend-paying stock with a high yield of 6.8%. Foolish special-situations analyst Jim Royal has been bullish on SUPERVALU for a long time, and the stock is part of our Rising Star Portfolios series as well.
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Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of SUPERVALU. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Motley Fool newsletter services have recommended buying calls on SUPERVALU. 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.