Corporate debt isn’t always a bad thing

If you see debt on the balance sheet of a company you’re considering as an investment, don’t rule it out — yet. Debt can be both bad and good.

First, the bad. If a company is saddled with a lot of debt, it’s locked into interest payments that it must make. 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 can make the payments, it’s spending money on debt that it might have been able to deploy elsewhere to better boost profits.

Now, the good. Debt can help businesses survive. 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.

Many great companies, such as Wal-Mart, Federal Express and Walt Disney, came to life because of early loans to their founders. Established companies can make good use of debt as well, borrowing to expand operations and grow business. Interest payments also decrease a company’s taxable income, as they’re deductible.

Investors willing to consider 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 Porcine Aviation (ticker: PGFLY). Glance at the notes in the annual report, and you may find that the effective interest rate for its debt is just 5 percent. If PGFLY is putting the borrowed funds to work earning say, 8 percent, then things aren’t so bad.

When companies need money, they typically can issue more stock or debt. Issuing stock can dilute the value of existing shares. Issuing debt can sometimes be more efficient. All things being equal, though, we prefer to see little debt on a balance sheet. Still, you needn’t balk at the first sight of debt. Just evaluate it carefully.

Ask the Fool

Q: How can I research the risks facing some companies I might invest in? — G.M., Medford, Ore.

A: Start at the horse’s mouth. Publicly traded American companies are required to file annual 10-K reports with the Securities and Exchange Commission. Accessible at Web sites such as http://quote.fool.com (and from the company itself, if you ask), these documents detail a company’s financial and operational progress and also address risks facing the business.

For example, eBay’s recent 10-K cites many risk factors, such as fluctuations in currency exchange rates and possible fluctuations in company profitability levels. It points out that the company’s performance may be harmed by fraudulent activities on its Web sites, increases in credit card processing fees, new and existing regulations, failures of the company’s computer systems and more.

Here are a few more risk-related notes: “Our business is adversely affected by anything that causes our users to spend less time on their computers, including seasonal factors and national events. … We must keep pace with rapid technological change to remain competitive. … We need to develop new services, features and functions in order to expand. … Our growth will depend on our ability to develop our brand.”

PepsiCo’s 10-K mentions international market risks, interest rate and currency exchange rate fluctuation, and volatility in commodity prices.

All companies have risks. Don’t let them scare you away, but do consider them.

Q: What’s a “block trade”? — C.P., Rutland, Vt.

A: It’s a big buy or sell order, generally involving at least 10,000 shares of stock or $200,000 worth of bonds. Institutions such as pension funds or mutual funds usually place block trades.

My dumbest investment

A couple of years ago, Southern Co. spun off a small energy firm named Mirant. As a shareholder, I received 79 shares of Mirant, worth about $2,500. My grandson had just graduated from high school, so I thought if I gave him the Mirant shares, it would interest him in the stock market and economics. I even bought 21 more shares to make an even 100. Mirant ended up filing for bankruptcy protection, and the shares are worth a big fat zero. Needless to say, my potential investor is disillusioned and now questions the integrity of all big corporations. — Ruth Rice Graham, Montgomery, Ala.

The Fool Responds: This is indeed an unfortunate introduction to the stock market. Point out to your grandson that while some firms do fail, many succeed. One good way to involve young people in stocks is to get them invested in companies they know and like, such as perhaps Nike, McDonald’s, Abercrombie & Fitch, PepsiCo, Microsoft, Dell, Starbucks, Harley-Davidson and Wal-Mart. Point teens to our Teens and Their Money area at www.Fool.com/teens or to our book “The Motley Fool Investment Guide for Teens” (Fireside, $14).