People’s views on debt differ wildly. For some, debt is no less a part of everyday life than eating breakfast or watching a favourite soap on TV. For others, however, debt is an evil phenomenon; to be avoided whenever possible and used only well within one’s means.
The rest of the population sit somewhere between the two and, interestingly, a person’s view of debt on a personal level is often mirrored in their investment decision-making. Debt-averse people tend to make debt-averse investors.
Of course, accountants and analysts will tell you that debt is not only needed under the capitalist structure under which we all work, rest and play, but is a more attractive means of financing a company than via shareholders’ equity. Certainly, the cost of debt is lower than the cost of equity but debt brings additional risk that needs to be factored in by investors.
My own view errs on the side of debt aversion; I appreciate that debt has a role to play in financing any business but am wary of it becoming too great. This leads me onto Diageo (LSE: DGE) (NYSE.DEO.US), whose debt-to-equity ratio stood at 114% as of its most recent interim results, which many investors (including me) would consider rather high and a potential red flag.
However, two reasons make me feel comfortable with Diageo having high debt levels. The first is that its interest coverage ratio is a very healthy 6.6 (for the previous full-year) — meaning interest payments on the debt were covered 6.6 times by operating profit.
The second reason is the nature of its business. Sales of alcoholic drinks tend to be fairly stable and, although revenue is not as visible as that of a utility, it is more stable than that of the average company. So, in other words, Diageo can live with higher debt than most of its FTSE 100 peers.
As ever, buyers of shares in Diageo will have to ‘pay for what they get’. A price-to-earnings ratio of 19.3 (using adjusted earnings per share to June 2013) is substantially higher than the FTSE 100 at 13.1. However, when compared to its sector (beverages: 25.8) and industry group (consumer goods: 17.4), it still looks worth buying.
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> Peter does not own shares in Diageo.
