It's almost becoming an article of faith that debt on the balance sheet is a bad thing, but it's easy to forget that in the right circumstances debt may be exactly what a company needs.
Defining the 'right' level of debt is as much an art as a science, and the art is to predict the future economic environment correctly. Deciding the correct level of gearing therefore involves having opinions on both the future business risks and financial risks, and there's a high degree of subjectivity to that.
Taking advantage of cheap and available money when you can get it may be the right thing to do, if you can be confident about your future cash flow, and if you can undo that situation before credit tightens.
When a director of a private equity fund was asked, in early 2007, what was the formula behind his company's success, he replied with remarkable honesty, “a bull market and lots of debt”. His company is suffering now, partly as a result of that policy; but it made huge profits when times were good and that shouldn't be dismissed. Sadly, though, its balance sheet was poorly prepared for the downturn.
It's a bit like stoozing, the Foolish practice of exploiting 0% credit cards when they were being offered -- perfectly sensible provided that you're in a position to repay the money when you need to. And it depends what you did with the money: Was it squandered or was it invested prudently, and how quickly could you get at it when you need it.
Aerospace company Rolls Royce (LSE: RR), and Chile-based copper miner Antofagasta (LSE: ANTO), are examples of companies that used debt sensibly when they required it, and then took the opportunity to pay it off before getting caught out.
And businesses with predictable income, such as United Utilities (LSE:UU), can happily continue with apparently high levels of debt without significant risk.
It's easy with hindsight to say that debt is bad, but it's all about the timing. And when the economy takes off again, whenever that will be, companies that have geared up will earn more for their shareholders.
But if a company bets the farm on getting that timing right, they better be correct. In the words of Nassim Nicholas Taleb: “It does not matter how frequently something succeeds, if failure is too costly to bear.”
More info: Avoiding The Corporate Debt Nightmare
Maynard Paton's Champion Shares portfolio has focused on companies with low debt or net cash. You can check out which companies he's backing now by taking a free 30-day trial.
