Debt isn’t always a bad thing

You’re considering investing in a company. You check out its balance sheet and see some debt. That’s not necessarily a red flag – 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 of us can relate to this, having 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 to boost profits.

Now, the good. Debt can help businesses survive and grow. 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, FedEx 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 the business. Interest payments also decrease a company’s taxable income, as they’re deductible.

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 Fingernail-on-Blackboard Car Alarm Co. (ticker: AIEEEE). 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 AIEEEE 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: In my IRA, can I shift money invested in mutual funds into other mutual funds or individual stocks? – K.T., Henderson, Ky.

A: If your IRA is maintained by a brokerage, you should be able to move your money from one fund to another, and to and from individual stocks. You won’t have to pay taxes on any gains, but you probably will have to pay trading commissions.

If your IRA is with a mutual fund family, you can probably switch between its own funds with minimal or no charge. You might not be permitted to invest in individual stocks at all. If so, you might consider transferring your IRA to a brokerage. Learn how to find the best brokerage for your needs at www.broker.fool.com.

Q: What’s the prime rate? – G.B., Reno, Nev.

A: It’s an interest rate (found in most newspapers’ business sections) – one that banks charge their best (lowest-risk) commercial customers. It’s important because lots of other interest rates, such as mortgage rates, home equity rates, credit card rates and other business loans, take their lead from the prime rate. A car loan rate, for example, might be calculated by taking the current prime rate and adding a certain amount to it. There actually isn’t a single prime rate. Each bank may set its own, but the major commercial banks tend to sport the same one most of the time.

The prime rate doesn’t change every day. It stays put for a while until major banks change their rates, generally moving in step with economic conditions.

My dumbest investment

I figured out early that you don’t make any real money working for companies – you have to own them, such as via stocks or mutual funds. I’ve always done my own investing, whether it was choosing funds inside my 401(k) or choosing the stocks to buy and sell in my brokerage account. I’ve never been afraid of risk as long as I spread it across a large number of different stocks. One of my biggest mistakes was trying to “catch a falling knife” – stock in Krispy Kreme Doughnuts – and not having the guts to just let it go. I’ve always looked at a fallen stock as a possible buying opportunity, but I let my love for the doughnuts cloud my better judgment. I eventually took what was left and put it in some companies that have done very well. – R.T.S., Sandston, Va.

The Fool Responds: Be careful – fallen stocks have often dropped for good reasons.