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., it can 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 Ferrellgas Partners (NYS: FGP) and compare it with its peers.
Suburban Propane Partners
Source: S&P Capital IQ.
While its peers look significantly leveraged, Ferrellgas' staggeringly high debt-to-equity of 1865.3% is through the roof. The figure is more than five times that of AmeriGas' (NYS: APU) . An interest coverage ratio of 0.9 -- implying that the company isn't bringing in enough revenue to cover its interest payments -- does not help, either. Also, Ferrellgas' current ratio of 1.0 means it is just about covering short-term liabilities.
In comparison, Suburban Propane (NYS: SPH) has the lowest debt-to-equity ratio in the group and also looks well-positioned to pay off its interest expenses. AmeriGas and UGI (NYS: UGI) are leveraged but are well-covered with healthy interest coverage ratios.
Ferrellgas traditionally enjoys its best spells during its second and third fiscal quarters, which constitute the peak demand period of October to March. However, in its second quarter ended Jan. 31, Ferrellgas' propane sales fell 7% as temperatures were unexpectedly higher than they were in the same period last year. Since propane gas is mainly used for heating, its sale spikes during winter, with summer months being pretty bleak.
The seasonal nature of the business aside, propane gas and equipment distributors are facing high wholesale propane costs, which won't help the company's bottom line, either. With Ferrellgas' revenue slowing down and the environment not really helping, it looks like the company may be in for a tough year.
Over the decades, small-cap stocks like Ferrellgas Partners have produced market-beating returns, provided they're value-priced and have solid businesses. Read about a pair of companies with a lock on their markets in "Too Small to Fail: 2 Small Caps the Government Won't Let Go Broke." Click here for instant access to this free report.
At the time thisarticle was published Shubh Datta doesn't own any shares of the companies mentioned above.The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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