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 two 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 US Airways Group (NYS: LCC) and compare it with its peers.
Interest Coverage Ratio
Southwest Airlines (NYS: LUV)
United Continental (NYS: UAL)
Delta Air Lines (NYS: DAL)
JetBlue Airways (NAS: JBLU)
Source: S&P Capital IQ.
US Airways' debt-to-equity when compared to its peers is staggeringly high. The airline suffered a series of losses since the last quarter of 2007 that resulted in negative retained earnings, leading to negative equity. However, it has managed to report numbers in the black since the second quarter of 2010, except for a minor blip in the first quarter of 2011. The company has very low total equity of just $159 million, which has led to the staggeringly high debt-to-equity ratio.
US Airways' interest coverage ratio is still pretty low, but at least it's above one, meaning it can meet its short-term interest requirements for now.
Obviously, US Airways isn't in the most sound financial position, but it should be able to meet its short-term debt requirements. We'll be watching to see what kind of free cash flow the airline can produce in the coming quarters.
To keep a close eye on US Airways -- or any other airline company -- click here to add it to your watchlist.
At the time thisarticle was published Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above.Motley Fool newsletter serviceshave recommended buying shares of Southwest Airlines. 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.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.