Increase In Use of Debt By US Firms
It is widely believed that the aggressive use of debt pays off in highly valued companies, despite its negative connotations. Many studies confirm this belief substantially. Corporate and personal tax, which vary in different situations, as well as the hidden costs of higher leverage, significantly affect the attractiveness of debt. Tax deductibility is factor which increases the attractiveness of debt financing. An example of a hidden cost is that financial leverage restricts the company’s flexibility to adapt financial policies to overall strategic objectives. Companies need to adopt an optimal capital structure that balances the debt-equity ratio and minimizes the cost of capital.
In 2016, corporate debt hit new highs even as earnings (EBITDA) of firms grew at a slower rate. The increase is use of debt by firms in recent years is interesting because their debt to earnings ratio usually rises during economic downturns, not during economic expansions. An analysis carried out by CNBC in the US has observed that most of the debt accumulation relative to earnings is not evenly spread out and has taken place in a few industries.
Over the last few years, the total annual EBITDA for the S&P 500 steadily rose and then became stable, while debt issued by the firms has been increasing in recent years. This has increased the amount of time it would take to pay off that corporate debt, as well the Net Debt/EBITDA ratio. In the US, much of this inconsistency between debt and earnings has been caused by energy, utility, and material companies such as Dominion Resources, Duke Energy, Ball Corp. and Chevron who have collectively accumulated 7 times more debt than earnings. The rest of the S&P 500 has a slightly lower ratio than it did a decade ago.
The debt accumulated by energy companies is widely known, as many such companies have faced bankruptcy over the years due to weakening oil prices, leaving large of amounts of debt in question. Some companies outside these sectors have also seen their debt ratios increase recently, as seen in most of the DOW 30 companies, such as McDonald’s and Caterpillar. It is difficult to quantify how much debt it too much but with the Federal Reserve increasing interest rates, the economy could enter a downturn.
As quickly as American companies acquire cash, they are accumulating debt as fast, if not faster. Total debt among more than 2,000 nonfinancial companies rose to $6.6 trillion in 2015, dwarfing the $1.84 trillion in cash on their balance sheets, according to a study released by S&P Global Ratings. The cash to debt ratio is the lowest it’s been in about 10 years, or just before the global financial crisis. As markets are coming to terms with increased interest rates, firms are taking on more debt than before with debt growing 50 times that of cash. Firms have registered $850 billion worth of IOUs compared to just $17 billion (1%) cash growth.
According to S&P credit analysts Andrew Chang and David C. Tesher, “This jump in debt reflects the scant resistance borrowers faced from yield-starved investors as companies pursued acquisitions and returned cash to shareholders”.
What’s more, most of the cash is concentrated in the top 1 percent while most of the debt resides with the rest. Total cash balances outside the elite actually declined 6 percent; by contrast, the other 99 percent held $6 trillion of the total debt load. The top 1 percent (25 companies) now controls more than half the corporate cash, up from 38 percent five years ago.
The cash-to-debt ratio fell to 12 percent among speculative-grade issuers, the lowest level since before the Great Recession.
“There’s a common misconception that companies are swimming in cash, when they are actually drowning in debt,” Chang said in an interview. “Liquidity is not what it appears.”
The surge in debt also comes amid rising defaults. The year has seen 72 defaults, up from 39 at the same time in 2015, S&P reported.
For the most part, defaults have been confined to energy-related issues; 29 are from oil and gas, 12 from metals, mining and steel, and one from utilities. S&P expects the default rate to continue to rise, from 3.9 percent of issuers in the past 12 months to 5.2 percent over the next year.
However, Chang said that while the surge in debt is troubling, it’s not yet at a crisis level. Companies are still able to refinance at low rates and have extended duration.
“While we had that initial freeze in the credit market early this year, investor appetite is picking up again,” he said. “As of today, credit conditions are receptive even to lower-rated issuers. What we’ve seen in the past is it doesn’t take a whole lot for that sentiment to turn.”
By Nishad MUKHERJI