Taking on a great deal of debt may seem like a bad thing, but that's not always the case. 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., it can comfortably meet its short-term liabilities and interest payments. Let's look at three simple metrics to help us understand debt positions.
The debt-to-equity ratio tells us what percentage of 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 Lockheed Martin (NYS: LMT) and compare it with its peers.
Interest Coverage Ratio
Boeing (NYS: BA)
Textron (NYS: TXT)
Northrop Grumman (NYS: NOC)
Source: S&P Capital IQ.
Lockheed has the highest debt-to-equity ratio in the list at a whopping 645.4% -- nearly twice that of its closest competitor, Boeing.
Although Lockheed's debt in the last 12 months has gone up by 29% to $6.4 billion, an interest coverage ratio of 10.7 times implies that the company is bringing in enough revenue to cover its interest payments. And a current ratio of 1.2 times shows that the company is reasonably well-positioned to cover all short-term obligations.
Peers such as Boeing and Textron are less leveraged than Lockheed, with interest coverage ratios of 11.1 times and 3.7, respectively. Northrop Grumman is the least leveraged of the group and enjoys a healthy interest coverage ratio, too.
Lockheed might be able to pay off its short-term obligations and manage its debt burden, but the adverse effects of the defense budget cuts could be the real looming threat to its business. It's only going to get more difficult for the defense behemoth to maintain growth. A case in point, the Pentagon recently delayed its decision to buy Lockheed's F-35 jets to help save about $15.1 billion. As fellow Fool Navjot Kaur points out, the postponement of this deal will just eat away at Lockheed's top line. To add to its misery, Italy, which had ordered 131 F-35s in 2002 to be delivered in 2018, will look to cut down on its defense spending as well. Last month, the European country cut the order by 30%, which amounts to 40 aircrafts, resulting in another blow to Lockheed's top line.
That's not all. Japan recently announced that it may scrap its order of Lockheed's F-35s if the defense company increases the previously determined price or pushes back the delivery date. This would mean a loss of $5 billion. Phew! Lockheed obviously stands to lose a lot.
If looming budget cuts and austerity measures are enough to keep you away from the defense sector, the Motley Fool has other great investing ideas in more promising industries and global markets. We've uncovered one Latin American retailer with so much promise that we've dubbed it "The Motley Fool's Top Stock for 2012." Our special report reveals a well-managed company poised for growth, so click here to download it now.
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 Northrop Grumman, Textron, and Lockheed Martin. 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.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.