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In the housing crisis, millions of people have seen firsthand just how damaging debt can be. But investors don't always realize that debt doesn't just have the capacity to screw up our personal lives -- it can also constrain businesses.
The downside of debt
Sure, debt isn't all bad. It lets people buy homes and cars and finance their educations, for instance. And it's a way for companies to get their hands on cash with which to build their business. But just as debt can force us not to take that big vacation because of mounting credit card debt, or leave us out on the curb if we lose a job and can't make our mortgage payments, it can hurt businesses, too. If a company faces steep interest payments, it has far less of its excess cash available for other purposes. If it enters a slump, with shrinking earnings, it's still on the hook for those interest payments, which can leave it on shaky ground and can leave shareholders heading for the exit.
Debt has challenged many companies. Sirius XM Radio (Nasdaq: SIRI ) , for example, went to the brink of bankruptcy in early 2009 because of its massive debt. In the end, it took some massive dilution for Sirius to survive -- although survive it has, with the company having managed to move into the black recently.
Meanwhile, although Altria (NYSE: MO ) is appealing to many investors for its strong dividend history, the company's long-term debt has been rising, from $7.3 billion at the end of 2008 to $12.2 billion in 2010, as the company financed liabilities from discontinued operations. If you have any concerns that its earnings are threatened by increased regulations, or by smokers who are kicking the habit over rising prices, then you should be concerned about its debt as well. Its global cousin, Philip Morris International (NYSE: PM ) , has an even steeper debt-to-equity ratio, but worrisome as that can be, both companies are currently earning enough to service their debt.
The big picture
Don't think of debt as an automatic deal-breaker. It can be used effectively, if it helps a company grow and the company is able to pay it down. Many casino companies, such as Las Vegas Sands (NYSE: LVS ) and MGM Resorts (NYSE: MGM ) , have taken on gobs of debt in recent years, building new properties as they focus on growth. Their debt levels are indeed a red flag, but a closer look shows Las Vegas Sands reducing its debt by more than $1 billion between fiscal 2009 and fiscal 2010. MGM Resorts has also been chipping away at its debt.
As you become a student of debt, you'll learn that it can exist in various forms. My colleague Matt Argersinger, for example, has pointed out that even though struggling Office Depot's (NYSE: ODP ) stated debt on its balance sheet doesn't look all that bad, it carries a lot of other obligations that are essentially debt as well -- for example, more than $2.5 billion in non-cancelable lease obligations for the many store locations that it doesn't own.
Finally, take note of the interest rates that companies are paying on their debt. You can often find these details in footnotes to financial statements. Genworth Financial (NYSE: GNW ) , for example, has taken on a lot of debt in recent years, most recently borrowing $400 million at 7.6%. It's paying more than I am on my mortgage.
There's a lot of debt out there, so it bears watching. A recent USA Today article noted that even as the U.S. debt level stands at $9.7 trillion, representing 63% of our gross domestic product, 147 out of the 500 companies in the S&P 500 have debt levels equal to or exceeding 63% of their annual revenue.
Factor debt levels into consideration when you look for great investments. Don't let debt put you or a company you invest in out of business.
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