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 the invested amount are higher than the cost of debt itself. If not, the company is heading 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 a few metrics to 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 US Airways Group (NYS: LCC) and compare it with its peers.
Delta Air Lines
United Continental Holdings
Source: S&P Capital IQ.
While most of its peers look significantly leveraged, US Airways stands out with a staggering debt-to-equity ratio of 3,044%. The carrier's debt has risen to $4.5 billion from $4.4 billion a year ago. The reason for its high debt is the negative retained earnings on the company's balance sheet, which has resulted in very low equity.
Peer Delta Air Lines' (NYS: DAL) debt to equity is not meaningful since it's running on negative equity. United Continental Holdings (NYS: UAL) , with a debt to equity of 705.15%, looks pretty leveraged, but an interest coverage ratio of 2.5 times helps it meet short-term obligations comfortably. Southwest Airlines (NYS: LUV) is the least leveraged of the group and also enjoys a healthy interest coverage ratio.
The airline industry has been hit by high fuel costs, making it difficult for some of these carriers to remain profitable. US Airways' fuel costs rose by 38%, affecting its profits significantly. In fact, in the past 12 months, profits are down 86% to a meager $71 million. Its interest coverage ratio of 1.4 times -- not the best in the group -- implies that the company is just about bringing in enough revenue to make its interest payments. A current ratio of 1.0 doesn't make for the best reading either. Its free cash flow is also down to $248.5 million from $314.5 million a year ago.
The problem for larger national carriers, such as US Airways and Delta, is that consumers now are choosing to fly cheaper airlines. A recent survey by the Temkin Group conducted on 10,000 U.S. consumers rated US Airways as poor and ranked it the lowest among major airlines. US Airways is not a stranger to poor financial conditions with two bankruptcies on its record in the last decade. The company's negative earnings and falling earnings on its books aren't great signs.
Also, as all of us know, the airline industry is prone to crises -- what better example than last year? Let's hope there isn't another crisis anytime soon.
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At the time thisarticle was published Shubh Datta doesn't own shares of companies mentioned above. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. The Motley Fool has a disclosure policy.
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