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 Abraxas (NAS: AXAS) and compare it with its peers.
Warren Resources (NAS: WRES)
GMX Resources (NYS: GMXR)
Callon Petroleum (NYS: CPE)
Source: S&P Capital IQ.
Abraxas has a debt-to-equity ratio of 154.5%, which, compared to its peers', is quite high. However, the company has been reducing the load, and debt has fallen to $104.1 million from $144.03 million a year ago. This year, Abraxas upped its capital expenditure budget to $60 million, which is nearly a 66% increase over last year's budget. Nearly half of this was allocated for developing unconventional horizontal oil wells in Bakken/Three Forks and Niobrara shale plays in the Rocky Mountain area. And the rest will go into more conventional plays in the Premium Basin and onshore Gulf Coast.
Abraxas recently met with drilling success in South Texas' Eagle Ford shale play. Blue Eagle, a joint venture of Abraxas and Rock Oil Co., drilled three wells in the play and plans to drill two more this year. Blue Eagle's two wells in DeWitt County currently produce 800 barrels and 1,500 barrels of oil equivalent per day. These new wells in Texas would help ramp up the company's production capacity.
Though Abraxas' current ratio is quite low, its interest coverage ratio of 1.4 times indicates that it is generating enough revenue to pay off interest requirements.
The company had been suffering a string of quarterly losses but managed to turn that around in its second quarter, recording a 69% jump in profits coupled with a 14% rise in revenue from a year ago. In its most recent quarter (the third quarter) Abraxas' profits rose more than two times from the preceding quarter. Thus, things are on the up for the Texas-based company.
In the quarter, it managed to increase production by 5% against the preceding quarter and is looking to hike output further in the coming quarters. These efforts may help Abraxas register more revenue and help increase cash flows. So if things go as planned, it should manage to reduce its debt going forward. While fellow Fool Isac Simon feels that the stock might not have that much to offer, the reduction in debt and increased production are things worth taking a look at.
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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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