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, 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 Safeway
Source: S&P Capital IQ.
Safeway has a high debt-to-equity ratio of 242%, greater than peer Kroger's leverage ratio, but it is just a hundredth of SUPERVALU's. In the last 12 months, Safeway's debt has gone up to $6.6 billion from $4.8 billion. But the company shouldn't have any real trouble managing its debt. It has a healthy interest coverage ratio of 4.1, which implies that the company is bringing in more than enough revenue to cover for its short-term interest requirements. Plus, its current ratio is well in line with that of its peers. The company has also generated reasonably good cash flow, to the tune of $324.0 million over the last 12 months, and thus looks well-placed to handle its debt situation.
Turning to it peers, SUPERVALU looks highly leveraged, which is probably the understatement of the year. The company has a total debt of $6.3 billion, which is nearly six times its market cap. I had earlier spoken about the grocer's debt situation and I'm pretty optimistic that it can take care of its debt. Kroger is the least leveraged of the lot and also has a healthy interest coverage ratio of 5.2. While it is important to invest in capital and look to expand into new markets, it is also important to keep track of how these companies manage the debt they've taken on.
Coming back to Safeway, it recently saw its first-quarter profits triple, but much of that was due to the fact that it was hampered by a hefty tax charge in the year-ago quarter. The problem for these retailers is that they've had to deal with the pressures of rising commodity costs in the face of weak consumer demand. As a result of which, the food space hasn't been the most profitable of late.
One thing I like about Safeway is that it has started to pay more attention to its non-core businesses such as property development as well as selling gift cards. This focus helped the company grow its top line by 2.4% this quarter. Safeway will look to build on this quarter going forward. To keep up to date on Safeway, use our free Watchlist service by simply clicking here.
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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 buying calls on SUPERVALU. The Motley Fool has a disclosure policy.