The Big Threat Is Still Corporate Debt

With yesterday's victory for those seeking to place limits on credit card companies, everyone's focused on trying to help consumers clean up their personal balance sheets. What many investors don't realize, however, is that corporations can often benefit from cutting debt just as much as you do in improving your personal finances.

Over the past two years, we've seen firsthand how much damage leveraged growth can do. Companies that used leverage to become too big to fail have cost taxpayers trillions in government bailouts -- and with a host of additional challenges still on the horizon, that figure could grow still further. Just look at how some highly leveraged companies have performed recently:

Source: Capital IQ, a division of Standard and Poor's.

To understand what got us into this mess -- and how we're going to get out of it -- it's important to know the benefits that borrowing offered to corporations and their shareholders.

A two-edged sword
A key decision that any business has to make is how to raise capital to run its operations. In general, a company has two choices: it can borrow money from those willing to lend, or it can sell equity stakes in the business to those who wish to become shareholders.

At first glance, you might think that selling shares seems like the obvious choice. After all, the money that shareholders invest isn't something the company ever has to pay back -- investors put their money at risk, and if things go wrong, they share equally in losses. In contrast, borrowing money means you have to pay it back eventually -- and typically make interest payments along the way. And if your business goes south, then lenders usually get first crack at whatever's left, often leaving shareholders with nothing.

The flip side of that argument, though, is what happens when the business does well. If you have an opportunity to make a $1 million investment that will return 20% in a year, then you can obviously find 10 investors willing to invest $100,000 each. At the end of the year, all 10 of you will each get $20,000 in profit.

However, if you find someone willing to lend you $900,000 at 10% interest, investing $100,000 to retain a 100% stake in the company will give you much bigger profits. The company will gross $200,000 on its investment, and after you pay $90,000 in interest and repay the loan, you'll have earned a net of $110,000 -- over five times as much as you did by using equity financing.

When leverage failed
Many of the debt-laden companies listed above did extremely well during the boom times from 2003 to 2007. On the other hand, some businesses that were more prudent with their borrowing, like Watson Pharmaceuticals (NYSE:WPI), didn't see as big a run-up as their leveraged rivals -- but their shares have held up much better during the bear market. And a few -- Sherwin-Williams (NYSE:SHW) is an example -- got the best of both worlds, producing strong results without leverage during the bull market while protecting itself from the bear.

With corporations as with people, not all debt is bad. Just as "good debt" like an affordable fixed mortgage can help you buy a home and save on rental costs, reasonable amounts of debt can help a company take on projects it would otherwise be unable to do, creating new profit opportunities. But whether it's a person struggling under too much credit card debt or a company having borrowed more than it can handle, excessive borrowing is never a good long-term sign.

Once the economy recovers, you can expect to see many companies start using debt again to leverage their profits. But while corporate leaders may not learn from their predecessors' mistakes, you'll remember the damage that debt can do -- and protect your portfolio accordingly.

To learn more about making the right moves with your investments, read about:

• Which stocks should you be selling now?
• Some bad news about dividend-paying stocks.
• Your best chance to profit this year.