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 Dunkin' Brands
Krispy Kreme Doughnuts
Source: S&P Capital IQ.
Dunkin' sports the highest debt-to-equity ratio in the group at 196.1%. However, the doughnut maker's debt has decreased from $1.8 billion to $1.4 billion in the last 12 months. When it comes to managing its debt, the company has an interest coverage ratio of 2.5, which implies that it is bringing in enough revenue to cover its short-term interest requirements. But compare that with the ratios of its peers and the figure doesn't seem great. However, its peers' debt loads are also much lower. An interest coverage ratio of 1.4 also implies that Dunkin' has time on its hands to take care of its debt.
Turning to its peers, McDonald's has the second-highest leverage ratio of the lot. Its also has a healthy interest coverage ratio. Krispy Kreme and Starbucks are the least leveraged of the bunch with hardly any debt on their books. They both have very healthy interest coverage ratios.
Dunkin' Brands, which includes the Dunkin' Donuts and Baskin-Robbins brands, is set to expand into emerging markets to somewhat compensate for its sluggish growth in the U.S. According to The Wall Street Journal, CEO Nigel Travis said, "Emerging markets are attractive because they are growing very quickly, they've a fast-growing middle-class, and they love American brands." The company is planning to open 350-400 stores abroad this year. This strategy may just pay off and Dunkin' would hope to emulate the international success of companies such as McDonald's and Yum! Brands. If it can do that, we can expect the company to rake in some green.
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Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of McDonald's and Starbucks. Motley Fool newsletter services have recommended writing covered calls on Starbucks. 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.