Why These Companies Should Survive

The Wall Street Journal recently reported that overall debt decreased in the second quarter of this year, as both lenders and borrowers became more risk averse. That's a sure sign that neither the debt market nor the overall economy has completely recovered from the 2008 meltdown.

Even more critically, it spells continued troubles ahead for firms that took on more debt than they really needed to run their businesses.

Who wants extra debt?
As strange as it may sound now, back when we had an extremely liquid debt market, many companies borrowed money for reasons other than expanding their business.

Common reasons to take on debt included the following:

• Funding share buybacks.
• Lowering the company's weighted average cost of capital (WACC).
• Rolling over (rather than paying off) existing, maturing debt.

In today's less liquid environment, firms that took on debt to pursue strategies like those are learning the hard way that unnecessary debt carries a substantial amount of risk.

Debt may sound good in theory, but it depends on both the company's business and the debt market remaining solid.

What can go wrong?
In an economic or industry-specific downturn, the downsides of debt quickly become apparent.

Companies with debt must service that debt with regular interest payments, while companies with stronger balance sheets can better afford to lower their prices to attract price-sensitive customers -- making them much more capable of waiting out a downturn.

In addition, downturns often expose market opportunities as weaker companies falter. If a firm's balance sheet isn't strong enough to take advantage of those time-sensitive chances when they become available, they aren't likely to come around again.

And that's just what can happen in an ordinary downturn. If the slowdown is accompanied by a severe credit crunch, as it is in this current economic mess, the problems can be compounded.

After all, if bondholders tire of financing a company, or if interest rates spike on a perception of higher risk, even an otherwise profitable company can be sunk by its debt burden.

How much is too much?
That's not to say all debt is bad -- carefully used, debt can help a company grow more and at a faster rate than it might have otherwise. As long as a company limits its use of debt so that it doesn't endanger the business in a downturn or a credit crunch, that borrowing is likely OK.

How can you tell the difference? Here are some good rules of thumb:

• The company's operations should generate significantly more cash than it's paying in interest. At five times coverage or above, it would take an incredible meltdown (one that makes this one look like a walk in the park) for a company to be at serious risk.
• The company should have a positive tangible book value. With more tangible assets than debt, the company can, in a pinch, offer to secure its financing needs with real property, rather than merely with its brands and a promise to pay. That could come in handy if a credit crunch makes it difficult to roll over debt once it matures.
• The company should be profitable. It's significantly easier for a company to convince creditors to keep loaning it money if it has already established a strong track record of earning enough to make the payments.

Who fits those criteria right now? Companies like these:

Data from CapitalIQ, a division of Standard and Poor's. All figures in millions.

Strength in a storm
In good times, taking on an extra helping of debt to artificially juice returns can be tempting. When the economic and financial tables turn, however, the dark side of debt can completely destroy those overlevered businesses.

In times like these, the companies that survive are the ones that kept their balance sheets strong when they had the opportunity to do otherwise.

At Motley Fool Inside Value, we know that tough times like these separate the winners from the losers. Wouldn't you rather be holding the companies that will most likely emerge victorious? We would, and we're constantly on the lookout for companies with the track record and proven financial discipline to survive this mess and emerge stronger. If you'd like to see what we're recommending today, just click here for a free, 30-day trial. There's no obligation to subscribe.

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At the time of publication, Fool contributor Chuck Saletta owned shares of Lowe's. Coca-Cola, Lowe's, and Wal-Mart are Motley Fool Inside Value recommendations. Automatic Data Processing, Coca-Cola, and PepsiCo are Income Investor picks. The Fool has a disclosure policy.