3 Reasons Debt Should be Avoided in Investing
Legendary artist Pablo Picasso once remarked that "every portrait is a self-portrait."
In that same regard, every item from the balance sheet or the income statement of a publicly traded company sketches an outline for an investor to view. The prominence of debt should never be overlooked on the balance sheet of any entity.
There are three reasons why excessive debt is a bearish indicator:
Companies should not need that much debt to prosper.
Growth should be produced from organic revenues. That evinces a strong business foundation for any enterprise: debt should not be needed to fund operations.
Every year, Warren Buffett writes in the annual report of Berkshire Hathaway (NYSE: BRK-A) that he looks for "businesses earning good returns on equity while employing little or no debt."
The debt-to-equity ratio for Berkshire Hathaway is a modest 0.32. Looking at the returns Buffett posts with his investing, it would seem to make sense for Berkshire Hathaway to max-out on debt in this low interest rate environment. But Buffett realizes the many perils of debt, so he avoids it.
One of the many liabilities of debt is missed opportunities.
Debt limits the options and viability of any entity. It can drag a company under during a period of adverse economic conditions. No company has ever gone bankrupt due to owing too little money. In his 2013 shareholder letter, Buffett wrote that "Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100."
Debt also diverts the resources of a company from more productive uses.
Cash flow must go to servicing the debt rather than financing future growth. Managerial decisions must always account for debt.
Excessive debt makes a company much less efficient.
Disney (NYSE: DIS) has a debt-to-equity ratio of 0.31, smaller than that for Berkshire Hathaway. It is even lower for Starbucks (NASDAQ: SBUX) at just 0.29. For Nike (NYSE: NKE), the debt-to-equity ratio is only 0.12.
All, like Berkshire Hathaway, are blue chip companies that could easily afford to carry more debt. But each has wisely chosen not to due to the burdens of debt.
Investors should bear that in mind when choosing which stocks to buy for the long term.
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