Many companies borrow to finance growth and expansion, and this is the way businesses grow and expand in a capitalist society. Loans are extended to companies, some of which may not have the equity capital to invest and grow, and interest is then charged on such loans.
Investors have to study the cost of using this debt (also known as “leverage” or “gearing”) as expensive debt can work against the company and cause it to bleed cash, while cheap loans are a good source of financing for a company if they can generate high returns on their investments. So let’s look at different scenarios and different interest rates charged and how these affect companies.
Cheap Debt (2% to 4%)
Companies which can secure cheap financing in the range of 2% to 4% have strong franchises, coupled with robust balance sheets, hard assets and healthy cash flows. Investors need to be aware that the reason banks and financial institutions are willing to lend at such low rates is that they perceive the risk of default to be low, and therefore they are willing to charge less. Such loans usually have hard assets like buildings, plant or equipment as collateral (i.e. a form of security), which can be seized and sold off in case the company (for whatever reason) cannot pay back the loan plus interest.
Companies which rely on cheap loans are usually savvy enough to know that they can make use of the cash to generate an even higher return which exceeds the cost of debt. In such cases, the low cost of debt represents a cheap source of funding for the company, and they should actively tap on this to grow their business. Companies have to be careful though, as taking on too much debt (debt-to-equity ratio of 100% or more) may prove risky should economic conditions change, even though the interest rates stay low.
Moderately to Expensive Debt (4% to 7%)
For companies which may not have the balance sheet strength or hard assets to put up as collateral, they may only be able to borrow at higher rates between 4% and 7%. Some companies may rely on debt financing and issue bonds or notes to the public promising a coupon rate within the above range. Investors have to make sure that the interest cost on the debt does not suck up a major portion of operating profit and cash flow. Otherwise, this debt could be an anchor which drags the company down, rather than providing effective funds for growth.
Expensive Debt (8% and higher)
Companies which have to borrow at rates higher than 8% are either desperate (as they have a weak balance sheet) and therefore willing to pay such high rates, or else they believe their return on investment is superior and will exceed their cost of debt. Investors should be wary though – the higher the interest rates on the debt, the higher the chance of the company not being able to sustain coupon payments or even pay back the loan. It is recommended that unless there is an extremely compelling story which justifies such a high cost of debt, investors should stay away from such companies.
The Foolish Bottom Line
It is always prudent for the investor to check a company’s annual report to assess the overall cost of debt. If the debt is too expensive, the investor should then question why the company is unable to rely on cheaper financing. This may tie in with either a weak balance sheet, declining business prospects or poor/inconsistent cash inflows for the company. More due diligence is thus needed for such a case, or the investor may choose to avoid it altogether to be safe.
The High Cost Of Debt And How It Strangles Companies Over Time
Expensive debt can break a good company and sap cash flows, so it's important to know what's considered low and high in terms of cost of debt.