Debt: It’s Not Always Bad

When you’re studying companies as possible investments, finding one with little or no debt is definitely a good sign. But it’s not always bad for companies to carry debt.

Some debt can be useful

— and sometimes almost unavoidable — for businesses, just as it can be for individuals. To buy a home, for example, you’ll likely need to take on a mortgage. Car loans and student loans are useful, too — as long as the terms and interest rates are reasonable. But high-interest-rate debt (such as that from credit cards) is another matter, and can be hazardous to our financial security.

Similarly, companies taking on debt can get an infusion of cash, allowing them to grow or sometimes just to survive. It must be manageable, though. When companies carry a lot of debt, they’re locked into required interest payments; if at any point they don’t have the cash to meet those obligations, they’re in trouble. Even if they can make their payments, they’ll be spending money that they might have been able to use in other, more productive ways.

Investors considering companies with debt need to evaluate whether the debt taken on is manageable, and whether the money raised and invested seems to be earning more than it costs.

Perhaps you’re worried about the debt load of Scruffy’s Chicken Shack (ticker: BUKBUK). The notes in its annual report should detail the interest rates it’s being charged. If you find that the effective interest rate for its debt is 4%, and if Scruffy’s is putting its borrowed funds to work earning 8%, that’s not very worrisome. But if Scruffy’s is generating $300 million in cash each year while owing $500 million in annual interest payments, that’s not so good.

Publicly traded companies can also raise money by issuing more stock via a “secondary offering.” But creating more shares of stock can dilute the value of existing shares, hurting current shareholders. So taking on debt may be a better choice. Still, it’s best to find little to no debt on a balance sheet.