Why You Can't Ignore Debt

Good old Goldilocks. Her adventures in oatmeal should resonate a bit for us investors, especially when we look at companies and their debt loads. Goldilocks came to mind when I read about the recent research by three Wharton Business School accounting professors. They looked at corporate debt and concluded that whereas some other studies have suggested that American companies are underutilizing debt, that doesn't seem to be the case -- instead, corporate debt levels, in general, are ... just right.

Let me back up a bit, though, and explain a few things about debt. Companies end up with debt because, obviously, they borrow money. When companies need moolah, they have a handful of options. For example, they can borrow, they can sell more stock, they can sell assets, or they can wait and tough it out, powering their growth purely via the money they make.

Funding options
These various options have pros and cons. Depending on the market environment, assets may not bring high prices. And once sold, the company may have fewer resources with which to generate money. (For example, selling a factory reduces production capacity.) Growing organically can be an appealing option, but it can be slow, and competitors with more funding may end up winning out.

Issuing more stock is a common way for public companies to raise money, but it has a key drawback, too -- it dilutes the value of existing shares. So now we arrive back at debt again. The obvious drawback is that the company becomes obliged to pay that debt back, with interest. This can be fine, though, if the company earns enough income to do so, and borrowing can even make a lot of economic sense. If a company can borrow $50 million at 6% interest, for example, and it can earn 10% on that money, the borrowing is well worth it. In addition, interest payments are usually tax-deductible, so that can help a company's bottom line, too.

So back to the three professors. They looked at the debt usage of several thousand firms between 1980 and 1994 and found that, contrary to many others' opinions, firms were not senselessly leaving interest-related tax deductions on the table. Instead, their debt usage was just about right.

Debt cautions
Why not use more debt? Well, debt increases volatility. It amplifies gains and losses. How so? Imagine that you have $10,000 to invest. If you borrow $5,000, you can invest $15,000 and can aim to make more money. But if your investment goes south, it will lose value, plus you'll still have to pay for that debt.

Debt also limits a company's options, requiring interest payments. It can become a serious issue if a firm's revenue and earnings are particularly lumpy, especially when much of a company's profits need to be applied to debt servicing.

What to do
So proceed with caution when you see a company with significant debt, and don't think too badly of a company that seems to be underutilizing it. Check out competitor debt levels, too, because debt levels generally vary by industry. Software or consulting companies, for example, tend to have low debt levels, whereas manufacturers and some utilities skew high. One measure to check is a firm's debt-to-equity ratio, which can be calculated by dividing total liabilities (or total long-term debt) by shareholder equity (both found on the balance sheet).

Here are some large-cap companies with relatively high long-term debt-to-equity ratios:

Data from CAPS.

Notice how their scores on Motley Fool CAPS vary, suggesting that thousands of investors have very different expectations of them. Clearly, a high debt load isn't swaying believers in Windstream, perhaps because they expect higher income to allow the company to pay off its debt in the future. Meanwhile, investors are worried about shrinking revenue for Marriott in our recession.

Remember that although these recessionary days are often the best time to buy stocks, it's also a dangerous time for businesses that have a lot of debt. So be sure to consider a company's debt when doing research. (You can often find the interest rates for its obligations in the footnotes to its annual report.) If it's high, then at least keep an eye on it, lest it end up weighing the company down inordinately.