Must-know: United’s ability to meet fixed obligations

By

Aug. 15 2014, Updated 8:00 a.m. ET

United’s ability to meet fixed obligations

Among all other factors, a company’s decision to add debt to its capital structure depends on the earnings power of the business. A business whose earnings are good can withstand a higher leverage compared to others. Therefore looking at leverage on a stand-alone basis makes the analysis incomplete unless it’s combined with the measure of the company’s earnings relative to its risk exposure. If the company has sufficient earnings, adding debt is a good idea because it reduces the cost of capital and increases economic value.

Earnings to fixed charges ratio

Article continues below advertisement

The earnings to fixed charges ratio is a very useful measure for investors and creditors to analyze a company’s capability to meet fixed commitments. A high ratio is better because it means that earnings are higher than fixed charges. As a result, there’s less risk of default. For the six months ending in June, 2014, United’s earnings were 1.2x it’s fixed charges. Fixed charges primarily include interest expense and capital expenditure. In the last five and a half years United’s earnings didn’t cover fixed charges twice when it had negative pre-tax earnings—once in 2009 and again in 2012.

Net debt/EBITDA

Net debt to earnings before interest, taxes, depreciation, and amortization (or EBITDA) is another measure of a company’s capability of repaying debt. The company with the lower ratio is preferable because it shows how many years a company needs to repay debt with the current net debt and EBITDA. Unlike debt to EBITDA, this ratio also adjusts for available cash balance which could be utilized to reduce debt. The higher the cash balance, the lower the net debt because net debt is calculated by subtracting the cash and marketable securities from the debt balance. As a result, the net debt to EBITDA will be lower than debt to EBITDA as long as the cash balance is positive. United’s debt to EBITDA is 3.44 while its net debt to EBITDA is 1.82. United’s (UAL) net debt to EBITDA is higher compared to its peers Delta (DAL) at 0.95 and JetBlue (JBLU) at 2.57. Southwest (LUV) and Alaska (ALK) are negative since their cash balance exceeds debt.

In some cases high leverage is acceptable if the company’s earnings are constantly high and predictable. However, in United’s case, both the measures of debt coverage indicate that there’s a need for United to reduce debt. Its earnings in the last five years haven’t remained constant or predictable and its net debt to EBITDA ratio is higher than its peers. A reduction in debt will improve its coverage ratios.

Advertisement

More From Market Realist