Taking on too much debt may sound like a bad thing, but it's not always. Sometimes, debt-laden companies can use this leverage to produce 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 maintained 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 aftermarket retailerAdvance Auto Parts (NYS: AAP) and compare it with its peers.
Advance Auto Parts
AutoZone (NYS: AZO)
O'Reilly Automotive (NAS: ORLY)
Pep Boys (NYS: PBY)
Genuine Parts Company (NYS: GPC)
Source: S&P Capital IQ. *AutoZone runs on negative equity.
Because of the uncertain economic conditions, many consumers in the U.S. have chosen to maintain their older cars as opposed to splurging on new ones. This has worked in favor of aftermarket retailers such as Advance Auto Parts. Advance has a high debt-equity ratio compared to its peers. This has possibly resulted from the fact that it is looking to expand its operations. In the last 12 months, its total debt has risen to $599.4 million from $301.0 million during the same quarter last year.
In the last year, Advance has opened a net 105 stores, taking its total store count up to 3,645. Last quarter, the company said it is also looking to invest in and grow its commercial and e-commerce business. These initiatives should help add to Advance's top line and also bring in more cash.
Advance has a free cash flow of $420.7 million. This, together with a high interest coverage ratio of 21.8 times and a current ratio of 1.1 times, means that Advance shouldn't really have any problems in paying off its short-term obligations and interest requirements.
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At the time thisarticle was published Shubh Datta doesn't own any shares in the companies mentioned above.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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