Most investors would agree that the use of debt to fund business operations can be a double-edged sword. During boom times, the clever use of debt can dramatically improve the return on shareholders capital. As a simple example, consider a company earning a profit of $10 for every $100 of shareholder funds. In this case, investors are earning a 10% return on their capital (ignoring taxes, inflation etc.). Now say a company is funded through a mix of 50% debt and 50% equity. In this case, investors will now be making $9.50 profit ($0.50 less for interest payments) but only needed to provide $50 in…
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Most investors would agree that the use of debt to fund business operations can be a double-edged sword.
During boom times, the clever use of debt can dramatically improve the return on shareholders capital.
As a simple example, consider a company earning a profit of $10 for every $100 of shareholder funds. In this case, investors are earning a 10% return on their capital (ignoring taxes, inflation etc.). Now say a company is funded through a mix of 50% debt and 50% equity. In this case, investors will now be making $9.50 profit ($0.50 less for interest payments) but only needed to provide $50 in capital. As a result, shareholders are now receiving a 19% return on their funds.
The argument against using debt to fund business operations is pretty simple – the higher the debt to equity, the higher the risk becomes especially when business conditions turn negative. Interest costs will eat into profit and companies can find themselves in trouble when banks start knocking on the door for repayments.
Investors don’t have to look very far to see the possible outcomes for companies that over-extend their balance sheets. Dick Smith Holdings Ltd (ASX: DSH), Arrium Ltd (ASX: ARI) and Slater & Gordon Limited (ASX: SGH) are just three companies from recent history that have destroyed shareholder capital through the sloppy use of debt.
While I accept that the smart use of debt can enhance shareholders returns, there are also a large number of companies that are generating excellent returns on shareholder funds without the help of borrowed money.
Three of the best, in my opinion, include:
REA Group Limited (ASX: REA) – According to CommSec, REA Group has earned a return on equity of around 36% over the past five years with the help of zero debt. A truly amazing performance and one that has helped to deliver an average shareholder return of 32.9% each year over the past 10 years. The shares consistently trade at a significant premium to the broader market and it’s not hard to understand why when you consider the returns the company achieves. Some investors may be concerned that domestic growth may be slowing but I think REA Group’s expansion into Asia and the US will bear fruits for investors in the years to come.
Flight Centre Travel Group Ltd (ASX: FLT) – The travel company’s first-half accounts showed zero long-term borrowings and short-term borrowing’s of just $21.2 million. On top of that, Flight Centre has a cash balance of $429.8 million that it is actively allocating to acquisitions and growth opportunities. Admittedly, earnings growth has slowed over the past two years due to the sluggish domestic economy but the company still generated a return of more than 20% on shareholders capital. More importantly, growth is expected to pick up over the next few years and this means periods of share price weakness could provide a good buying opportunity for investors.
Sirtex Medical Limited (ASX: SRX) – Sirtex has been debt free since 2006, yet is has consistently delivered a return on equity of 20%. Pleasingly for investors, this figure has been steadily increasing over recent years as profitability has improved and is now heading towards 28%. The shares have been sold off heavily over recent months for a number of reasons, but at around $30 a share, I think investors could do far worse than consider investing in a company that is expected to grow earnings at double digits for at least the next few years.
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Motley Fool contributor Christopher Georges owns shares of Sirtex Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.