When Debt Is Good vs. Bad

If a company is saddled with a lot of debt, it's locked into making interest payments. If it doesn't have the cash to cover these at any point, it's in deep doo-doo. If you've ever found yourself on the dark side of debt after racking up charges on your credit card, you can probably relate.

Now, the good. 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.

Debt can be a boon for businesses, just as it can help us. Many great companies, such as Federal Express (NYSE: FDX) and the Walt Disney Co. (NYSE: DIS), came to life because of early loans to their founders. Established companies can also make good use of debt, borrowing to expand operations and grow their business. Interest payments also decrease a company's taxable income, as they're deductible. Investors willing to consider companies with debt need to evaluate whether the debt taken on is manageable and whether the capital 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: AIEEE). Glance at the notes in the annual report and you find that the effective interest rate for its debt is just 5%. If AIEEE is putting the borrowed funds to work earning, say, 8%, then things aren't so bad.

When companies need money, they typically have two main choices: They can issue more stock or take on debt. Issuing stock dilutes the value of existing shares. Debt can sometimes be more efficient, as its after-tax cost can be much cheaper than equity.

All things being equal, though, we prefer to see little debt on a balance sheet. Companies that can grow without using debt or issuing extra stock are in a more powerful position than others. They have more flexibility and more opportunity, if a sizable chunk of their income won't be eaten up by debt payment obligations. Still, you needn't balk at the first sight of debt. Just evaluate it carefully.

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