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 Venoco (NYS: VQ) and compare it with its peers.
Occidental Petroleum (NYS: OXY)
Plains Exploration & Production (NYS: PXP)
Berry Petroleum (NYS: BRY)
Source: S&P Capital IQ.
Venoco's debt-to-equity ratio when compared to its peers looks scary. This astoundingly high figure is mainly because Venoco has a low equity of $39.7 million as compared to its debt of $681.7 million. Till the first quarter of this year, the company had been operating under negative equity owing to a string of quarterly losses, which also turned its retained earnings negative. But in the last two quarters, equity has turned positive and the most recent quarter's equity of $39.7 million is much better than the $189,000 it had in the preceding three months.
Venoco has reduced its overall debt to $681.7 million from $697.5 million a year ago. A thing to note is that the debt is slightly higher than Venoco's market cap, which stands at $524.19 million. However, with an interest coverage ratio of 1.2 times, the company is bringing in just about enough money to cover its interest expenses.
I expect Venoco's debt-to-equity ratio to go down as the company increases its retained earnings and therefore its equity. A few months ago, Venoco announced that its subsidiary Ellwood Pipeline has the final go-ahead to build an onshore pipeline, which will transport crude oil from its South Elwood field. This facility should help add about 7 million barrels to Venoco's production. Once the pipeline goes online, Venoco expects to be able to earn $5-$7 more on each barrel produced. The South Elwood field produces nearly 2,000 barrels a day. I feel this should help boost Venoco's top and bottom lines and cut debt.
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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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