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 heavy equipment company Manitowoc (NYS: MTW) and compare it with its peers.
Caterpillar (NYS: CAT)
Terex (NYS: TEX)
Source: S&P Capital IQ.
Manitowoc has the highest debt-to-equity ratio on the list, at a whopping 401.2%. Manitowoc's debt in the last twelve months has come down to $1.90 billion from $2.04 billion. With an interest coverage ratio of 1.4, the company is bringing in enough revenue to cover for its interest payments. A current ratio of 1.1 also implies that the company should have no problem meeting all short-term obligations.
Peers Caterpillar and Terex are significantly less leveraged than Manitowoc. Caterpillar enjoys a healthy interest coverage ratio of 18.1, putting it in a comfortable position. Terex, with an interest coverage ratio of 1.1 and a current ratio of 2.1, is also reasonably well placed to meet its short-term requirements.
The best part about Manitowoc is that it is a diverse company serving two business lines -- one in construction equipment and the other specializing in manufacturing equipment for the food industry. The company also strengthened its product portfolio recently, as it launched 12 cranes and 50 new products meant for the food industry.
The crane maker is also looking to emerging markets such as Brazil, India and China to drive growth. The Asian markets have been particularly fruitful as revenue from the region has doubled in the last five years. It plans to expand further in this region which should help power its growth. Thus, Manitowoc seems to be moving in the right direction, but it's certainly a situation worth watching. To stay on top of all developments from Manitowoc, make sure to add it to your Watchlist today by clicking here.
At the time thisarticle was published Fool contributor Shubh Datta doesn't own any shares in 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.