Sometimes debt on a company's balance sheet is bad, and sometimes it's good.
First, the 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. Many individuals can probably relate to this, having experienced the dark side of debt when racking up charges on credit cards. Even if the company does have the cash, it won't be available to be used for other things. Also bad.
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, too. Many great companies, such as FedEx (NYSE:FDX) and Disney (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. If they borrow at say, 6%, and earn a 12% return on that investment, they're doing well and creating value for shareholders.
Interest payments also decrease a company's taxable income, since 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). Glancing at the notes in the annual report, 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, since 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 other firms. If a sizable chunk of their income won't be eaten up by debt payment obligations, that means more flexibility and more opportunity. Still, you needn't balk at the first sight of debt. Just evaluate it carefully.
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FedEx and Disney are both Motley Fool Stock Advisor picks.
