Taking on too much debt may sound 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 well-positioned to handle the debt it has taken on -- i.e., 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 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 Boeing (NYS: BA) and compare it with its peers.
Lockheed Martin (NYS: LMT)
Northrop Grumman (NYS: NOC)
Textron (NYS: TXT)
Source: S&P Capital IQ.
Boeing has a high debt-to-equity ratio of 227%, but it's only around half of Lockheed's ratio. Boeing's debt in the last 12 months has remained more or less unchanged and stands at around $11.6 billion. On the face of it, the debt looks quite high, but when you consider the fact that Boeing operates in a capital-intensive industry, the figure isn't shocking. An interest coverage ratio of 12.6 implies that the company is bringing in more than enough earnings to cover its interest requirements. Throw in free cash flow of $1.7 billion with a current ratio of 1.2, and we see that there's plenty of cushion.
Peer Lockheed has the highest leverage ratio of the group, but also has a very healthy interest coverage ratio. Textron, too, with an interest coverage ratio of 4.7 and a current ratio of 2.4, looks comfortably placed. Northrop Grumman looks the best of the lot, as it is the least leveraged and also has the highest interest coverage ratio of the group.
Coming back to Boeing, the aircraft manufacturer is fresh off a strong quarter in which it saw its profits jump by 58%. A lot is riding on the success of Boeing's fuel efficient offering -- the 787 Dreamliner. The company is looking at reducing the cost of making the Dreamliner as well. The expected production cost for the 60th plane of this series should be around 40%-50% of production costs on the first Dreamliner delivered in September.
However, the company still has a significant backlog on its books, with the total backlog up to $380 billion from $356 billion a year earlier. Thus, the manufacturer is looking to boost production by upward of 40% by 2014 with plans to manufacture 10 787s per month by 2013. That's quite an ambitious plan if you consider that its main assembly plant in Everett, Wash., currently produces 3.5 planes per month. Boeing is hoping that when its plant at North Charleston, S.C., is functional, it'll be able to produce five aircraft a month by the end of 2012. Do you think Boeing can pull of the production ramp? Leave your comments below.
The Dreamliner has hit a few roadblocks along the way, but Boeing is nevertheless positioned well in the industry and could overtake Airbus in terms of planes delivered in 2012. On top of that, Boeing pays a nice dividend of 2.3%. For investors clamoring for dividends, take a look at The Motley Fool's list of "9 Rock-Solid Dividend Stocks." We invite you to download a free copy today.
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 Lockheed Martin, Textron, and Northrop Grumman. 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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