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; 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., 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 Express Scripts
Catalyst Health Solutions
Source: S&P Capital IQ.
Express has the highest debt-to-equity ratio among the entire group at 415.7%. Its total debt has gone up to $11.5 billion from $2.5 billion in March 2011, largely due to its whopping $29.1 billion merger with Medco Health Solutions. The company said that in order to fund a portion of the deal, it took on a $4 billion loan, resorted to $8.4 billion in debt financing, and used $1 billion cash. It also raised $3.5 billion through a bond sale earlier this year. All of this more than explains the sudden rise in debt, as well as the stark difference in leverage that Express has compared to its peers.
Express has a solid interest coverage ratio of 6.2, which implies that it is bringing in enough revenue to cover its short-term interest payments. It also has a good current ratio of 2.1 -- the best among its peers -- apart from generating a healthy free cash flow of $2.5 billion over the past 12 months. Express certainly looks well-placed to manage its debt burden.
Looking at its peers, both CVS and Catalyst are hardly leveraged and have robust interest coverage ratios of 11 and 20, respectively, which show that they shouldn't have any real trouble meeting their short-term interest requirements. Although these companies don't have much debt on the books, it's always good to keep track of how they manage their debt, even if it is a small amount.
Coming back to Express, this company is fresh off its merger with Medco, which effectively created the largest pharmacy benefits operator in the U.S. It is still in the process of integrating Medco into its operations, but once that it is done, the combined company should serve nearly 115 million customers, along with having the potential to earn nearly $110 billion a year. If everything goes as planned, I see no real difficulty for Express to pay off its debt.
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Shubh Datta doesn't own any shares in the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Express Scripts Holding. The Motley Fool has a disclosure policy.
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