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, debt holders 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. One of the most common liquidity ratios is the Current Ratio. This compares a company's short-term assets to its short-term liabilities: Current Assets / Current Liabilities. The higher the current ratio, the greater a firm's ability to pay its bills as they come due. But not all current assets can be converted to cash quickly. For instance, a company may have trouble selling obsolete inventory in a short amount of time to meet current obligations. That's why many analysts will strip out inventory when looking at a company's liquidity. That calculation is known as the Quick Ratio: (Current Assets - Inventories) / Current Liabilities. An even more conservative ratio is the Cash Ratio, which measures only a company's cash (including cash equivalents and short-term securities) against its current liabilities: (Cash + Cash Equivalents + Short-term Securities) / Current Liabilities. This ignores both inventory and receivables and is the strictest of all liquidity ratios. These ratios will vary across industries, so it's important to compare them to their peers. But in general, the higher the ratios the better. One of the most common solvency ratios is the Debt/Equity ratio: Total Liabilities / Shareholder Equity. The higher this ratio, the more leveraged a company is. Another important ratio to measure a company's ability to meet its long-term debt obligations is the Interest Coverage Ratio. This takes a company's earnings before interest and taxes over a given period and compares it to its interest expense: Operating Income / Interest Expense. The higher the debt burden a company has, 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. So it's important to consider industry averages. 4 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 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 four names from the list: Noranda Aluminum (NOR) Quick Ratio: 0.8
Cash Ratio: 0.1
Interest Coverage Ratio (TTM): 0.8
Debt/Equity: 17.6 Noranda Aluminum Holding Corporation produces Primary Aluminum Products, as well as rolled aluminum coils. PetroQuest Energy (PQ) Quick Ratio: 0.5
Cash Ratio: 0.1
Interest Coverage Ratio (TTM): (negative)
Debt/Equity: 36.8 PetroQuest Energy is an oil and gas exploration and production company. Rentech (RTK) Quick Ratio: 0.7
Cash Ratio: 0.4
Interest Coverage Ratio (TTM): (negative)
Debt/Equity: 6.0 Rentech owns and operates wood fibre and nitrogen fertilizer businesses. ClubCorp (MYCC) Quick Ratio: 0.6
Cash Ratio: 0.2
Interest Coverage Ratio (TTM): 0.9
Debt/Equity: 9.0 ClubCorp owns and operates private golf and country clubs and private business clubs in North America. 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 four companies appear to be in over their heads at the moment. Todd Bunton, CFA is a Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor and Surprise Trader services. Want More of Our Best Recommendations? Zacks Executive VP, Steve Reitmeister, knows when key trades are about to be triggered and which of our experts has the hottest hand. Then each week he hand-selects the most compelling trades and serves them up to you in a program called Zacks Confidential. Learn More>>
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