Personal finance websites usually advise us to avoid taking on debt if necessary.
They correctly point out that excessive debt can drain your cash flow, putting you at mercy of creditors such as banks and finance companies.
However, an exception can be made if the debt was taken up for “good” reasons, otherwise known as “good debt”.
In a nutshell, good debt is used to purchase assets that can grow in value and provide us with a better return over time.
Some pertinent examples include property and education.
The same can be said for companies as well.
While we often tout the benefits of a “clean” balance sheet (i.e. one with zero debt), the reality is that some level of debt may actually be beneficial for a company.
Debt has never been cheaper
The COVID-19 pandemic has resulted in governments around the world unleashing unprecedented levels of stimulus to boost their respective economies.
The US Federal Reserve (“Fed”), which sets interest rates that are used as a benchmark for many other countries, slashed rates to near-zero back in March in response to the damage wrought by the coronavirus.
And it may be a long while before these rates are ever raised, judging by the tone taken by the Fed.
The US wants to ensure that the economy has fully weathered the economic storm and is on a clear path to recovery before even considering raising rates again.
The lower for longer rates has had a positive impact on the cost of debt, lowering it to levels not seen in the last decade.
Companies can now borrow very cheaply and use the money to generate a return higher than the cost of debt.
These low rates are here to stay and act as a strong impetus for businesses to borrow to grow their business.
The smart use of debt
Businesses can make use of debt smartly by investing in initiatives or ventures that provide a higher return.
Before this can happen, some important criteria should be met.
The business should have adequate physical assets to pledge as collateral for the loans, and such assets should hold their value over time.
Another factor to consider is the company’s free cash flow generation capability.
A business with a consistent track record of free cash flow generation can afford to take on some debt to grow.
Companies with strong competitive moats or near-monopolies, such as Singapore Exchange Limited (SGX: S68), or SGX, have also proactively taken on loans to grow.
Last October, SGX announced that it had established a S$1.5 billion multi-currency debt issuance programme.
In January this year, the bourse operator announced the acquisition of smart-beta firm Scientific Beta for EUR 186 million.
SGX drew down on a loan worth EUR 302 million to fund the acquisition, at a weighted average interest rate of just 0.36%.
Avoiding excessive debt
Of course, the decision to tap on debt for growth should be tempered with prudence.
History is littered with many examples of companies that have gone bust after taking on excessive debt.
Ezra Holdings Limited (SGX: 5DN) is one such example.
The oil and gas support services firm collapsed in March 2017, a victim of the oil price crash of 2014.
Its balance sheet for its fiscal year ended 31 August 2016 shows total debt of slightly over US$1 billion, while its cash balance stood at just US$34 million.
Another victim of high debt levels was Hyflux Limited (SGX: 600), a water and wastewater treatment firm.
Hyflux sought court protection back in May 2018 to reorganise its business and deal with its liabilities.
Its balance sheet as of 30 June 2018 had cash amounting to S$257.8 million, while gross debt stood at S$1.57 billion.
Get Smart: Monitor that debt closely
In summary, debt should not always be viewed negatively.
If used wisely by astute management, it can boost returns for investors.
The cost of debt is also at historic lows, enabling many businesses to tap on it to generate decent returns.
The key is to monitor a business’ debt level closely to ensure that it does not grow to excessive levels.
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Disclaimer: Royston Yang owns shares in Singapore Exchange Limited.