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., whether 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 retailer Macy's
Interest Coverage Ratio
Source: S&P Capital IQ.
Macy's is the most leveraged of the group, with a debt-to-equity ratio of 115.3%. However, the company's debt has fallen to $6.95 billion from $7.08 billion a year ago. Macy's shouldn't really have any trouble managing its debt. It has a strong interest coverage ratio of 5.5, which means that the retailer is bringing in more than enough revenue to fund its short-term interest requirements. Plus, its current ratio of 1.5 is more or less in line with that of its peers. To add to that, Macy's is generating enough cash, and its free cash flow currently stands at a healthy $1.33 billion over the last 12 months.
Turning to its peers... J.C. Penney is less leveraged than Macy's. But it doesn't have the best interest coverage ratio, implying that the retailer isn't bringing in enough revenue to cover its short-term interest payments. But with a current ratio of 1.9, it has some time to turn this around. The company is currently undergoing a transformation, as new CEO Ron Johnson looks to reinvent Penney's in a completely new image. I am bullish on the company, and believe that it may be a good pick in the long run. Kohl's is the least leveraged of the lot and has a very healthy interest coverage ratio and current ratio to show for it.
Coming back to Macy's, it's fresh off a strong quarter in which profits surged by 38%, helped by a 4.4% rise in its top line, with same-store sales up 4.4% as well. The company said that it has benefited from Penney's new "non-promotional price streamlining" through gaining more customers. Macy's has also reported a strong performance in its online segment, with online sales rising 33.7%. More recently, the company has joined hands with Chinese e-commerce site omei.com in an effort to foray into the fast-growing online Chinese market. Macy's surely appears to be on the right track. To keep tabs on the company going ahead, use the help of our free Watchlist service by simply clicking here.
Looking for a broader perspective on retail stocks? Note this: There is a major shift in the retail space that no company will be able to sidestep. Find out more in our report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail."
Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. 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.