When Debt Is Good

It’s easy to assume that savvy investors should avoid companies with debt. Too much debt can be a red flag, but debt isn’t necessarily all bad. If a company is carrying a lot of debt, it’s locked into interest payments that it must make. If at any point it doesn’t have the cash to meet its obligations, it’s in trouble. (Many of us can relate to this if we’ve racked up debt on credit cards.) Even if the company can make the payments, it’s spending money on debt that it might have been able to use in other, more productive, ways. But debt can help businesses survive and grow, too. It’s certainly necessary for many of us individuals, as without mortgages, we would never be able to buy our homes. Car loans and student loans are sometimes prudent choices, too — especially when interest rates are low. Many major companies, such as Subway, Amazon.com, Whole Foods Market, United Parcel Ser- vice and Starbucks, exist because of early loans to their founders. Established companies can make good use of debt, too, borrowing to expand operations and grow their businesses. And interest payments, which are deductible, can decrease a company’s taxable income. Investors considering companies with debt need to evaluate whether the debt taken on is manageable and whether the money raised and invested is earning more than it costs. Perhaps you’re worried about the debt load of Acme Explosives (ticker: KBOOM). Glance at the notes in its annual report, and you may find that the effective interest rate for its debt is 5 percent. If Acme is putting the borrowed funds to work earning, say, 8 percent, then things aren’t so bad. But if Acme is generating $100 million in cash annually while owing $200 million in annual interest payments, that’s not so good. When companies need money, they can typically issue more stock or take on debt. Issuing stock may dilute the value of existing shares, so debt might be better. Overall, though, on a balance sheet, little to no debt is best.