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Sunday, June 12, 2011

Watch Out for Stocks with High Debt Load

If you asked a bank for an unsecured loan, but had huge credit card bills, a big mortgage payment, a couple of high-end leased cars and two children in private schools, you might get a quick “No".

The bank would be doing you a favour by not digging you any deeper in debt than you already are and setting you up for a hard financial fall that will likely come if you keep spending beyond your means.

Yet, that’s just what some companies do when their business is booming (or so they think).

To finance growth, the company piles on debt in all forms from lines of credit with the bank to vendor credit to issuing bonds or other longer-term arrangements.

Leverage often works great when a business is growing and gaining market share, but all that borrowed money has to be repaid.

If business conditions reverse, the borrowed money still has to be repaid and that can be a problem when cash flow is shrinking instead of expanding.

The lesson for investors is to keep an eye on the amount of debt a company is piling up. Too much debt will drain the company of cash to meet payments and if cash becomes tight, the company may face a severe cash crunch.

How much is too much debt?

That depends on the industry. A utility or cable television company, for example, must spend a tremendous amount of money upfront and wait years before the payoff begins. Other companies don’t need as much debt – service companies for example.

In any case, look at others in the same industry for comparisons. If your target company is out of line with the industry, it may be a warning sign.