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 desirable.
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 financial ratios.
Liquidity vs. Solvency
Two of the best types of ratios to consider are liquidity and solvency ratios.
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 long-term survival.
Two of the most common liquidity ratios are the Current Ratio [Current Assets / Current Liabilities] and the Quick Ratio [(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 Debt/Equity 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 industry averages.
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:
Windstream Holdings (WIN - Free Report)
Current Ratio: 0.76
Quick Ratio: 0.57
Interest Coverage Ratio: 1.34
Emeritus Corp (ESC)
Current Ratio: 0.71
Quick Ratio: 0.54
Interest Coverage Ratio: 0.61
Casella Waste Systems (CWST - Free Report)
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 for Zacks Investment Research and Editor of the Income Plus Investor service.
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