Having debt is bad, right?
In every introductory accounting class that I teach at least one MBA student will ask me that question.
As with many things in life, the answer is “it depends”.
The word debt has negative connotations so it does not surprise me when students assume that debt in a company is bad. There are advertisements about debt relief and the evils of personal debt. TV financial advisors warn against taking out personal debt. Debt payments can become overwhelming for some people, so many people view debt as something that is bad.
The truth is that most people have personal debt in one form or another. Our society incentivizes debt so if you attempt to remain debt free, you may be leaving opportunities on the table. Borrowing money can provide opportunities that would otherwise be missed. In this respect, debt can be good, but my father once told me that too much of a good thing can cause problems. As I have lived my life, I have found his words to be true.
When it comes to business financing, it is easier to overcome the negative emotions that surround debt in order to see how a certain level of debt can be a positive attribute for a company. To put the situation in a more positive light, we use the word leverage to describe the use of debt for financing assets in a company.
Financial leverage increases return on equity and earning per share for the owners of a company when times are good. In other words, owners make more money when leverage is used in a profitable company. Increased leverage increases risk, so with additional risk, comes additional reward. When a company is making money, the rate of return will outperform interest rates that are charged for debt financing. When earning profits, cash inflows will outpace debt obligation payments. Owners do not need to provide additional equity funding for investments, so value is created by leverage when conditions are favorable. If the company does not utilize leverage, management would not be optimizing the return to investors.
Of course, when a leveraged company loses money it is still obligated to pay the debt payments even when cash inflows are not sufficient to cover debt service. This situation causes losses to amplify cash outflows. Losses combined with debt payments can quickly drain cash reserves to levels that threaten insolvency or perhaps bankruptcy.
There are a number of ratios that can be analyzed in order to determine the amount of financial leverage of a company and help to determine if the debt is still at a manageable level. Here are two commonly used leverage ratios:
Debt to Equity Ratio: Take the balance of interest- bearing debt and divide by the balance of owner’s equity. Both figures are found on the balance sheet of the company. This ratio provides the amount of leverage for a company by comparing the amount invested in the company by the owners to the amount of debt at any given time.
Times Interest Earned Ratio: Take the Operating Income of the company and divide by the interest expense. Both figures are found on the income statement. This ratio calculates how easily interest expense can be paid by the day to day earnings of the company.
Publicly Traded Corporations
In the past few years, many publicly traded corporations have initiated policies to buy back stock from shareholders in order to take advantage of historically low interest rates as well as favorable tax rates. As a result, leverage ratios have been driven higher for many large and successful corporations.
As my class studied the ratios of some of these publicly traded companies, I was surprised to see billions of dollars in negative equity on the books of some highly successful companies. In other words, the owners of these companies have nothing invested and therefore the companies are entirely financed by debt. In fact, shareholders have been compensated beyond earnings by utilizing debt to finance the cash payouts. Here are a few examples of companies that carry billions of dollars in negative equity:
AutoZone: Negative Shareholder Equity of 1,713,815,000
Home Depot: Negative Shareholder Equity of 3,116,000,000
Starbucks: Negative Shareholder Equity of 6,231,000,000
McDonalds: Negative Shareholder Equity of 8,210,300,000
Boeing: Negative Shareholder Equity of 8,300,000,000
Phillip Morris: Negative Shareholder Equity of 9,599,000,000
(Figures are derived from the most recent annual reports filed by the companies)
These companies have tremendous amounts of debt but have no worries about paying their obligations. One reason is that they are probably too big to fail. Do you remember the 2008 economic recession when large corporations were not allowed to fail? In times of crisis, political influence will allow these large corporations to survive so there is no need to pay attention to debt ratios.
Recently the actions of the US Government again reinforced this policy. The government pledged to back all corporate bonds including junk bonds in the recently enacted Cares act providing pandemic relief. In fact, many companies that have been flourishing during the pandemic including Amazon took advantage of the situation to issue bonds with record low interest rates. The additional financing will enable companies to further compensate shareholders. Historically low interest rates are still attractive to investors in the bonds because the government guarantee eliminates risk of default.
Small businesses do not have the same safety net that is available to large corporations during economic downturns so owners must pay close attention to debt levels. These businesses fail on a daily basis even in times of economic prosperity. Even though the owners did nothing wrong, an unprecedented amount of small businesses will be forever lost due to the Covid 19 pandemic. Small business owners do not have the luxury of allowing the equity that they have invested in their business to turn negative. In economic downturns, small business owners must adjust quickly to changing conditions or else they are forced to invest their own personal savings in order to survive.
Debt can allow any company to pursue opportunities that might not otherwise be available, but in a small business too much debt can turn an Entrepreneur’s American dream into a nightmare. Small business owners need to scrutinize debt in their company at all times. The Debt to Equity Ratio, and the Times Interest Earned Ratio can help to determine what level of debt might be too much of a good thing.
If you would like me to help you to learn how to interpret your company’s financial information or if you would like to discuss how to evaluate the amount of debt that is currently in your company, please send me a message in LinkedIn or contact me at firstname.lastname@example.org.