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 payments at any point, it's in deep trouble. Many individuals can probably relate to this situation, having experienced the dark side of debt from racking up charges on credit cards.
But now the good news. 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 advertised on matchbook covers.
Debt can be a boon for businesses, just as it can help us. Many great companies, such as FedEx and Disney, came to life thanks to early loans to their founders. Established companies can make good use of debt, too; they can borrow to expand operations and grow their business, for example. And since interest payments are deductible, they also decrease a company's taxable income.
Still, 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 Fingernails-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 they can take on debt. Issuing stock dilutes the value of existing shares, while debt can sometimes be more efficient, since its after-tax cost can be much cheaper than equity.
Companies that can grow without using debt or issuing extra stock are in a more powerful position than others are. 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.
FedEx and Disney are both Motley Fool Stock Advisor recommendations.
