Following the bursting of the housing bubble and subsequent
financial crisis, debt has become somewhat of a 4-letter word to
many Americans. And while there are many benefits to debt-free
living for households, in the corporate world, debt is often
The Benefits of Debt
In order for a company to grow, it must finance that growth. This
can come from retained earnings, issuing debt, or by selling new
shares of stock. While many investors seem to prefer debt-free
balance sheets, there are actually quite a few benefits for a
company to have some debt:
- It's cheaper than equity financing.
- Interest payments are tax deductible, while dividends paid to
shareholders are not.
- Issuing debt does not dilute shareholder value, unlike
issuing new equity.
Too Much of a Good Thing...
Of course too much debt can be crippling for a company if business
turns south. The more debt financing a company uses, the greater
its risk of bankruptcy.
If a company is distressed, you can bet that those interest
payments will get sent out before any dividend checks. And in the
event of a bankruptcy, debtholders have first claim on company
assets over stockholders.
So what's the right balance of debt and equity for a company?
Ideally, a company should operate around its optimal capital
structure - where its weighted average cost of capital (WACC) is
minimized. But finding the right amount of debt-to-equity may be
more art than science.
There are ways, however, for investors to tell if a company is
carrying too much debt. And that involves looking at various
Liquidity vs. Solvency
Two of the best types of ratios to consider are liquidity and
Liquidity is a measure of the firm's ability to meet its short-term
obligations. Solvency is a measure of the firm's ability to meet
its long-term obligations. It's more of a measure of the firm's
Two of the most common liquidity ratios are the
[Current Assets / Current Liabilities] and the
[(Current Assets - Inventories) / Current Liabilities]. These will
vary across industries, so it's important to compare them to their
peers. But the higher the ratios the better.
The most common solvency ratios are the
Interest Coverage Ratio
[Operating Income / Interest Expense] and the
ratio. The more leveraged a company is, the lower its Interest
Coverage Ratio will be and the higher its D/E ratio will be. Again,
these will depend on what industry a company operates in.
Capital-intensive businesses will typically carry larger amounts of
debt on its balance sheet. Again, it's important to consider
3 Companies Drowning in Debt
I ran a screen for companies with poor liquidity and solvency
ratios. While this doesn't necessarily signal imminent bankruptcy,
these four companies all appear to be cash-strapped and
overleveraged at the moment. And that's a dangerous place to be,
especially if business doesn't improve.
Here are 3 names from the list:
Current Ratio: 0.76
Quick Ratio: 0.57
Interest Coverage Ratio: 1.34
Current Ratio: 0.71
Quick Ratio: 0.54
Interest Coverage Ratio: 0.61
Casella Waste Systems
Current Ratio: 0.76
Quick Ratio: 0.65
Interest Coverage Ratio: 1.02
The Bottom Line
For corporations, a prudent amount of debt can be beneficial. But
too much debt will increase the risks of bankruptcy and put
shareholders at risk. These 3 companies appear to be in over their
heads at the moment.
Todd Bunton, CFA is the Growth & Income Stock Strategist
and Editor of the
Income Plus Investor service
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