Taking on too much debt may sound like a bad thing, but debt isn't always bad. 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 lower share counts translate into higher earnings per share.
However, when assuming debt, a company should check 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 -- that is, can it comfortably meet its short-term liabilities and interest payments? Let's look at some 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 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 Ford (NYS: F) and compare it with its peers.
General Motors (NYS: GM)
Toyota (NYS: TM)
Honda (NYS: HMC)
Source: S&P Capital IQ.
Compared to its peers, Ford's debt-to-equity ratio stands at an overwhelming 660.1%. Don't fall out of your seat -- Ford's debt of $103.98 billion includes both the company's finance and automotive wings.
However, what's more relevant here is its automotive debt. Ford's total automotive debt maturing in the next five years (until December 2016) stands at $4.975 billion, and at $8.119 billion thereafter. Thus, at a total of $13.094 billion -- which is $6 billion less than what it was a year ago -- the debt now seems much more manageable, doesn't it?
By comparison, General Motors and Honda look less leveraged, and enjoy healthy interest coverage ratios. Toyota's debt-to-equity is more than GM and Honda's, but its interest coverage is a robust 28 times, the highest amongst its peers.
When it comes to paying off debt, Ford also looks comfortably placed and has been making strides to reduce its debt burden. A point to note here is that Ford's automotive gross cash stood at $22.9 billion at the end of last year, which was $9.8 billion more than its debt. In addition, the company has a healthy interest coverage ratio of 10 times, which is bringing in enough green to cover its interest payments. Thus, I wouldn't really worry about Ford's debt.
Plus, the auto industry is on the rise, and according to J.D. Power and Associates and LMC Automotive, sales in the U.S. are expected to hit 14 million vehicles this year. Automobile sales in the U.S. used to average close to 17 million annually before the economic crisis, but it has so far failed to regain those pre-recessionary levels, hitting a low of 10.4 million in 2009. Since then, sales have somewhat recovered with last year seeing 12.8 million vehicles sold; however, we mustn't forget that last year the industry was hampered by the Japanese earthquake and tsunami.
With sales rebounding, we can expect Ford to gain from this and continue to rake in the green, at the same time reducing its debt load.
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At the time thisarticle was published Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. The Motley Fool owns shares of Ford Motor. Motley Fool newsletter services have recommended buying shares of Ford Motor and General Motors; and creating a synthetic long position in Ford Motor. 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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