The Motley Fool

Debt. Why it Can be Good or Bad for a Business

It may sound like a very basic question, but why do companies take on debt? Is this part and parcel of the normal daily operations of a company or is there a deeper reason why they need to borrow money? Investors should always question the motivation for borrowing as it can sometimes signal red flags.

I will detail some of the common reasons why companies borrow and also provide explanations as to whether I feel each reason is justifiable. Investors who witness an increase in debt should always be alert as to the reasons and if no justification is provided, they should approach the C-suite management to find out more details.

Borrowing for an acquisition

Companies who plan to make an acquisition normally tap on different sources of funding. These could include rights issues, a secondary placement of shares or additional borrowings. If the acquisition is a large one, the company may even borrow aggressively in what is known as a “leveraged buyout”. The acquired company’s assets are used as collateral for the loan, and the acquirer takes up a significant chunk of debt to finance the buyout.

A leveraged buyout may sound good in theory, but if problems crop up with the acquisition, the acquirer will have to contend with two major issues – the debt load they took up for the acquisition, as well as the acquisition itself turning sour.

Borrowing to build new assets

Another reason for borrowing is to construct new assets, for example, a new headquarters, silo, factory or plant. Reasons may include growth and expansion, relocation to a better office to facilitate better business prospects or an increase in production capacity to handle higher demand.

Investors need to assess the stated reason for the higher borrowings and tie this to the company’s goals and plans. Situations, where the company’s free cash flow may not be high or consistent enough to support the higher debt level, may cause the investor to turn wary.

Borrowing as part of working capital requirements

Yet another reason to borrow would include higher working capital requirements. Some companies need to tap on additional funds as a result of business expansion, where they may need to put pay upfront for costs relating to a contract or to purchase additional inventory in line with higher expected demand. This is perfectly fine as long as the company really sees higher business volumes coming through. However, if business sentiment makes a sharp U-turn, the company may end up with higher levels of debt and less revenue and cash flow to compensate for it.

The Foolish takeaway

As can be seen, companies borrow for a wide variety of reasons. The investor should diligently study each reason and ensure that the higher debt load can be adequately supported by better business prospects and higher cash flows. If not, this should be a red flag and investors should closely monitor the company for any signs of distress.

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The information provided is for general information purposes only and is not intended to be personalized investment or financial advice.