Posted on Tue, Apr. 8, 2008
You're considering investing in a company. You check out its balance sheet and see some debt. That's not necessarily a red flag; debt can be both bad and good.
First, the bad. If a company is saddled with a lot of debt, it is locked into interest payments that it must make. If it does not have the cash to cover these at any point, it is in deep trouble. (Many of us can relate to this, having racked up debt on credit cards.) Even if the company can make the payments, it is spending money on debt that it might have been able to use to boost profit.
Now, the good. Debt can help businesses survive and grow. Consider that most people would never be able to buy their homes without debt. Without car and school loans, many of us would probably be driving used cars and taking correspondence courses we found on matchbook covers.
Many great companies, such as Wal-Mart Stores Inc., FedEx Corp. and the Walt Disney Co., came to life because of early loans to their founders. Established companies can make good use of debt, as well, borrowing to expand operations and grow the business. Interest payments also decrease a company's taxable income, as they are deductible.
Investors considering companies with debt need to evaluate whether the debt taken on is manageable and whether the money raised and invested is earning more than it costs.
Perhaps you're worried about the debt load of Fingernail-on-Blackboard Car Alarm Co. (ticker: AIEEEE). Glance at the notes in the annual report, and you may find that the effective interest rate for its debt is just 5 percent. If AIEEEE is putting the borrowed funds to work earning, say, 8 percent, then things are not so bad.
When companies need money, they typically can issue more stock or debt. Issuing stock can dilute the value of existing shares. Issuing debt can sometimes be more efficient. All things being equal, though, we prefer to see little debt on a balance sheet. Still, you need not balk at the first sight of debt. Just evaluate it carefully.
