Taking on too much debt may sound like a bad thing to you, but that is not always the case. Debt-laden companies can actually 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 -- firstly, the equity shareholders value doesn't get diluted, and secondly, 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 cost of the debt itself. Or else, the company is headed for some serious trouble.
As an investor, it's prudent to see whether a company is strongly positioned to handle the debt it has taken on, i.e., can the company comfortably meet its short-term liabilities and interest payments? Hopefully, this article will help shed some light in this regard. To do so, let's take a look at three simple metrics that help us understand the debt position of a company.
The debt-to-equity ratio tells us what percentage of the debt as opposed to equity a company uses to help fund for its assets.
The interest coverage ratio is an easy way of measuring how easily a company can pay off the interest expenses on its outstanding debt.
The current ratio tells us whether a company can pay off its short-term liabilities through its short-term assets.
Let us now take a look at the debt situation of Campbell Soup (NYS: CPB) and compare it to that of its peers.
General Mills (NYS: GIS)
ConAgra (NYS: CAG)
H.J. Heinz (NYS: HNZ)
Source: S&P Capital IQ.
Campbell's is currently in a transformative stage as new CEO Denise Morrison takes over the reins of the world's top soup maker. Her first task as CEO is likely to address slumping U.S. soup sales. She seems on track to do just that; as Campbell is launching 27 new soups and looking to rely less on price promotion to help boost sales. It is also planning to add new products to its Prego and Pace sauces.
Interest coverage ratio and current ratio suggest the company should have no real problems in paying off its short-term obligations. But it remains to be seen how consumers will receive the new products they will offer.
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At the time thisarticle was published Shubh Datta doesn't own any shares in the companies mentioned above.Motley Fool newsletter serviceshave recommended buying shares of H.J. Heinz. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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