Many companies borrow money. It can make a great deal of sense. If you can borrow money at 5%, then build widgets and sell them and earn 8%, you’re making 3% on someone else’s money. But it’s important to look at the nature of a company’s debt.
Usually it’s categorized as long term or short term debt. Long term debt would be in the form of bonds or preferred stocks. Short term debt is often issued as a line of credit from a bank or other institution. Why do you care? With long term debt, no one can come to the company and demand their money back until the debt comes to term. With short term debt, it might only be six months or a year before a bank has the opportunity to reduce the amount available to borrow, raise the rate, or cancel the credit line altogether.
That doesn’t happen very often. However, it was a key contributor to companies that ran into trouble in 2008. If they had long term debt in place, all they had to do was keep making interest payments. But the failure of some companies and closed end mutual funds then was related to them having a great deal of short term debt. When the credit markets froze, so did the access to capital. It doesn’t have to be a financial debacle. A bank could just decide they don’t like the risk profile of a company, and refuse to issue them more credit.
When you’re researching a company, it’s an important question to ask. Is their debt long term or short term, and what are the consequences if those funds were not available? It’s a worst case scenario, but one that you need to understand before you purchase shares.