The fall of consumer electronics retailer Dick Smith Holdings Ltd (ASX: DSH) into voluntary administration earlier this week has seen a media frenzy offering suggestions for the cause, but there's one vital issue many have overlooked.
Dick Smith lost the support of its bankers, who were unwilling to continue lending to the company to prop the business up. When a business requires debt to continue normal operations, that suggests there are fundamental underlying issues with the business.
Had Dick Smith had a decent cash balance and no debt, the retailer may well have been able to continue operating – and therein lies the lesson for investors. Instead, the retailer had taken on more than $70 million of debt under three facilities allowing the retailer to borrow up to $135 million.
Debt can be a double-edged sword, allowing companies to juice up returns and profits when times are good, but weigh like a boat anchor when businesses are struggling. At times like that, management virtually cedes control of the company to their bankers.
We've seen this time and time again.
During the Global Financial Crisis (GFC), many property trusts (A-REITs) which had taken on huge amounts of debt to increase returns were forced to raise billions in equity capital from shareholders to placate their bankers. Several went to the wall, and many retail investors now avoid the sector altogether.
Child care centre aggregator ABC Learning famously collapsed after taking on too much debt and overpaying for acquisitions.
Many more companies have been forced to raise equity capital to shore up their balance sheet in recent times after taking on too much debt. Santos Ltd (ASX: STO) and Origin Energy Limited (ASX: ORG) in 2015, mining services company Boart Longyear Ltd (ASX: BLY) in 2009, Billabong International Limited (ASX: BBG) in 2013, Atlas Iron Limited (ASX: AGO) last year and the list goes on.
Rare earths miner Lynas Corporation Ltd (ASX: LYC) still has a large debt balance hanging over it, as does iron ore producer Fortescue Metals Group Limited (ASX: FMG), making both companies more 'riskier' to invest in.
By comparison, Flight Centre Travel Group Ltd (ASX: FLT) has virtually no debt ($33 million) and $565 million in cash (excluding client cash).
Another issue with debt that is often overlooked is that it can boost a company's return on equity artificially. A better valuation measure to consider is to look at return on invested capital (ROIC), which includes both debt and equity.
Foolish takeaway
Investors need to be aware of the implications of investing in companies with large debt balances. Some companies with long-life assets such as airports, toll roads, hospitals and other infrastructure can sustain high levels of debt, but many companies should use debt sparingly.
