"Kee" Points with Jim Kee, Ph.D.


  • What is Capital Structure?
  • Current Corporate Debt Concerns

 

Markets sold off last week on aggressive comments from President Trump regarding trade with China and Mexico, then bounced back (apparently) as those countries issued more conciliatory statements towards trade (WSJ). We will see how it goes this week. Today I want to address the issue of increasing corporate debt, which has been vying for media headlines with the ongoing trade-war.


What is Capital Structure?

Capital structure refers to the amount of debt (borrowing money) and or/equity (selling ownership shares) a firm employs to finance its operations. For example, if a company had no debt and only issued stock, it would be 100% equity financed. If it then issued debt (i.e. borrowed money) and bought back all of the outstanding shares of stock it had issued, it would be 100% debt financed. Usually firms lie somewhere in between, with some debt and some equity financing. That’s called a firm’s “capital structure.” Firms with assets that are “plastic” (i.e. fungible) and hard to monitor tend to be financed more by equity, because lenders (debt-holders) to such firms would have a hard time figuring out, on an ongoing basis, whether or not their money was being spent wisely. Companies with a lot of research and development (R&D) tend to fit this description. On the other hand, companies with very specific (and easy to monitor) assets, like oil refineries, tend to have more debt. Debt is also seen as a disciplining device for firms generating more cash than they have reinvestment opportunities, as it forces management to pay out surplus cash flow in the way of interest payments. However, this also makes firms riskier during business downturns, as they have less cash on hand to use for a cushion. Because of this, it is often asserted that highly levered firms make economic downturns worse because they are forced to fire workers and liquidate assets in order to make their interest payments. You can see that the question of what a company’s capital structure should be involves a lot of trade-offs. The real point I want to make here is that financial economists have not worked out a final theory of what the “optimal capital structure” of a firm should be.


Current Corporate Debt Concerns

But any model of optimal capital structure would surely have corporate debt increasing as its price – the interest rate it has to pay – decreases, and indeed in the past several years we have seen historically low interest rates coincide with increases in corporate debt. Is this cause for alarm? Probably not, according to a recent paper published by the Federal Reserve Bank of New York titled, “Is There Too Much Business Debt?” Corporate debt-to-GDP ratios are near 50-year highs (as interest rates are near fifty-year lows), and debt-to-profits have increased since 2012 (though declining since 2016). But the authors make a case, close to my heart on debt discussions (!), that outstanding debt has to be compared to assets, and that the annual interest payments that companies have to pay to service their debt (i.e. the service cost) have to be compared to annual income or profits (i.e. their ability to pay). On the first measure, the authors look at corporate debt-to-book assets and find that it is within historical norms, as is a similar measure, debt-to-market cap. As an aside, the authors point out that the former may overstateleverage if book values are less than market values, while the latter may understate leverage if market values are stretched. On the second measure, service cost, they look at cash earnings or profits (EBITDA) relative to interest expense, which is known as “interest coverage” (i.e. can you cover your interest payments with your earnings?). Because of strong earnings, this measure remains above its historical median, which means interest coverage (or safety, if you will) is above average. So it too is not a big concern. To sum it all up, I think this paper gives a more intelligent and balanced view of the current corporate debt environment than what is found in the media. Corporate debt levels are not without concern, but they are certainly not the end of the world either, nor a precursor to financial Armageddon.