Must-read: Assessing leverage for gold miners like Goldcorp

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Sep. 26 2014, Updated 4:00 p.m. ET

What is financial leverage?

Financial leverage is the extent to which fixed income instruments like bonds and preferred stock are used in a company’s capital structure. Financial leverage’s benefits arise because the interest expense paid on debt instruments is tax-deductible. This provides a tax shield. However, financial leverage has value only up to the point when the assets purchased with debt capital earn more than the cost of debt.

 

How much leverage can gold miners take?

How much more gearing a particular company can handle without damaging its value to shareholders depends on its current financial standing and future growth prospects. We’ll now look at how North American gold majors are doing on the financial leverage front.

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As the above chart shows, all the major gold miners—except for Iamgold (IAG)—are investment-grade, though the outlook for Barrick Gold (ABX) is increasingly negative, owing to problems with Chile mines and pressure on cash costs. Yamana Gold (AUY) has started doing well after its recent acquisition of Osisko Mining. The S&P is positive but still has a BB+ rating, which is the highest speculative-grade rating. Goldcorp (GG) is doing well overall.

Debt to equity

A worsening debt-to-equity profile?

The debt-to-equity ratio indicates long- and short-term debt’s proportion to shareholders’ equity. A higher ratio indicates a higher proportion of debt in the capital structure.

On this measure, ABX isn’t doing great either. It has the highest ratio among peers and had reached a peak of 2.35 in Q2 2013 before stabilizing at 1.78 for the last three quarters.

GG is doing the best on this measure as well. It has a ratio of only 0.18. It should be able to take credit from the market at a competitive interest rate.

For Newmont (NEM), the ratio is steadily rising. Along with a negative outlook from rating agencies, this trend would hamper the company’s future debt issuances and may come at an increased interest rate.

There are other measures—like interest coverage ratios, Altman-Z scores, and liquidity ratios—that you should also use to form a holistic view.

The Gold Miners Index ETF (GDX) is another way of gaining exposure to this sector. It invests in all the above-mentioned stocks. The SPDR Gold Shares (GLD) tracks the spot gold price.

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