Is Tesco PLC Dependent On Debt?

Are debt levels at Tesco PLC (LON: TSCO) becoming unaffordable and detrimental to the company’s future prospects?

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2013 was a highly challenging year for shareholders in Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US), with its shares underperforming the FTSE 100 by 15% (the FTSE 100 gained 14% and Tesco fell by 1%).

Indeed, concerns surrounding the future sales potential of the business, the continued threat from the likes of Aldi and Lidl (as well as other listed peers) and question marks regarding the strategy of the business have all contributed to a relatively poor performance from Tesco.

Furthermore, 2014 has not started well. Shares in Tesco are currently down 2.8% in 2014, again trailing the FTSE 100, which is up by just under 1%. The market, it appears, is pricing in continued difficulties for the company. However, is it fully pricing in the financial risk of Tesco? Or is Tesco’s dependency on debt-fuelled growth largely being ignored by the market?

Excessive Debt?

With a debt to equity ratio of 65%, Tesco’s financial gearing is arguably best described as moderate, with every £1 of net assets being matched by £0.65 of debt. Certainly, it is using debt to maximise returns to investors, but does not appear to have an excessive amount of debt on its balance sheet. Indeed, a company whose main product is food could arguably live with a higher level of debt, since its revenue stream should (in theory) be more stable than the average FTSE 100 listed company.

Furthermore, despite Tesco experiencing highly challenging trading conditions of late, its interest coverage ratio remains very healthy. It currently stands at 7.8, which means that Tesco was able to cover its net interest payments nearly eight times (using operating profit) in its most recent financial year. This is encouraging and highlights the potential for Tesco to increase debt levels so as to further improve returns to investors.

Looking Ahead

Of course, the current outlook for the UK supermarket sector seems poor. As mentioned, increased competition and consumers with less disposable income are combining to squeeze profits at Tesco and its peers. However, Tesco continues to offer a yield of 4.5%, trades on a price to earnings (P/E) ratio of 10.7, and is forecast to return to growth in 2015. Allied to its only moderate levels of debt, this means that Tesco could still be worth a place in Foolish portfolios. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Peter owns shares in Tesco. The Motley Fool owns shares in Tesco.

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