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 propane gas and equipment distributor Ferrellgas Partners (NYS: FGP) and compare it with its peers.
Suburban Propane Partners (NYS: SPH)
AmeriGas Partners (NYS: APU)
UGI (NYS: UGI)
Source: S&P Capital IQ.
Ferrellgas' debt-to-equity ratio, when compared to that of its peers, is staggeringly high. It is almost five times as much as its peer AmeriGas' debt to equity. An interest coverage ratio of 1.2 times implies that the company is comfortably placed to make its short-term interest payments, but the thing to note is that its interest coverage ratio is much lower than that of its peers. Its current ratio indicates it is in a position to cover its short-term liabilities with its short-term assets, if so required.
However, the company has had a tough run of late, with high propane costs eating into its bottom line. Ferrellgas reported a loss in its most recent quarter as the cost of wholesale propane shot up 46%. Also, as fellow Fool Keki Fatakia had pointed out, retail sale volumes have dropped as Ferrellgas has suffered because of the poor U.S. economic conditions. Low demand from the agricultural industry this year as it endured a relatively dry harvest also hit volumes. The company is likely to remain under pressure as it tries to combat the coupled effect of low demand and rising input costs. Adding to its woes is a relatively high debt load that has more or less remained unchanged in the last 12 months or so. Thus, the prospect of Ferrellgas reducing its debt anytime soon remains bleak. What say you, Fools?
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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 services have recommended buying shares of UGI. 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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