Shipping companies are capital intensive, so looking at the financial leverage for these companies is of utmost importance for investors. Debt-to-asset ratio is an indicator of the financial leverage of the company. This ratio tells us the percentage of assets financed by debt and indicates the financial risk of the company. A higher ratio means higher financial leverage.
For riskier companies, investors generally demand a higher return on capital, both equity and debt. Debt acts like a lever, magnifying both gains and losses. Companies that have high debt in poor times have a higher chance of going bankrupt. But high leverage can also be positive if those companies do survive. Debt has a fixed cost and with an increase in revenue, the profits increase by a higher percentage. Also issuing debt instead of equity does not dilute shareholders. Cost of debt interest is a tax-deductible expense, which reduces a company’s tax burden.
Comparing companies on leverage
Frontline (FRO) has an enormous amount of debt of $892.82 million on its balance sheet. Its debt-to-asset ratio is 93.4%. This ratio is very high as compared to its peers. Having such high leverage is similar to other capital intensive companies like upstream companies (XOP). Teekay Tankers (TNK), Tsakos Energy Navigation (TNP), DHT Holdings (DHT), and Euronav have a debt-to-asset ratio of 55.64%, 51.84%, 47.28%, and 40.18%, respectively. Nordic American Tanker (NAT) has the lowest ratio in the industry of 24.2%.
Frontline’s risk of high leverage
If Frontline (FRO) is not able to pay down this huge amount of debt on time, it could lose vessels if lenders foreclose on their liens. Also in such a condition, it will be difficult for the company to raise additional debt to increase its fleet size. 13.5 years, the average fleet for Frontline (FRO), is above the average world fleet age of 9.5 years. Going forward, the company needs to substitute these vessels for newer vessels in order to maintain the same fleet size.
Other companies have a decent debt-to-equity ratio, and financial leverage should not be a major concern for these companies.