I see so many corporate balance sheets of large companies today, even companies that pay dividends, which reflect liabilities (obligations) that significantly exceed assets (resources). When you exclude any intangible assets (goodwill too) from the asset base, the liabilities are that much greater than the assets. Of course, this means that the companies reflect negative equity since assets less liabilities leave equity. Typically long term debt forms a large portion of the company obligations in these situations where liabilities are greater than assets.
Debt management is an integral component of profit generation. Many companies seem to have worked hard to perfect the management of debt financing to extract every last dime of financial-leverage-related earnings benefit. Borrowing money to make money is especially attractive in a low interest rate environment like we’ve experienced for several, several years now. The cost of such capital (interest) is low, it is tax deductible, and it is a fixed (known) cost regardless of how much money is generated from the assets financed by the debt obligation.
Individual stock investors look to each next quarterly earnings report in hopes that the company will surprise the investment community with higher earnings per share (eps) than expected and thereby send the stock price ever upward. Further, company managers are provided incentives, via stock options and bonus plans, to produce greater and greater profitability. So, it’s not surprising that corporate management would be sorely tempted to test the limits of financial leverage in order to extract another penny of earnings per share for every next quarter. Again, the shareholder community rewards them for higher company profits.
The downside of excessive financial leverage was suddenly “visible” during 2008 and into 2009. It had existed before that time but was exposed when lending became virtually frozen. The problem with heavily depending on debt financing for the next breath is that the ability to keep rolling over debt is essential.
The only financial statement to expose a company’s debt position is the corporate balance sheet. Back in 2008 and 2009, relative to the companies I was holding stock in, I was glad my investments were centered in companies with very healthy balance sheets. Knowing that the companies were liquid enough to keep paying the day to day operating costs for an extended period of business slow-down was important; weathering the uncertain storm was front and center; during this great time of uncertainty, the limelight was not on the company’s ability to produce higher eps every successive quarter.
There are benefits to use of financial leverage (debt financing). There is also a point where another dollar of debt endangers the very life of the company should something unforeseen come along. “Choose Stocks Wisely” includes a presentation of my two balance sheet quality standards, namely a liquidity standard and a solvency standard. The two quality standards, taken together, represent my effort to assess potential threats to a company’s financial health reflected on the balance sheet, including the threat of excessive financial leverage.
Thanks Paul I enjoy your book and working with your quality standards. Borrowing makes sense only when the return on invested capital exceeds the interest you have to pay for your capital. In my experience, you need a much larger return on invested capital that what you borrowing costs. The why has to do with the ephemeral nature of capital projects. They do end. But as long as you borrow, the interest needs to be paid.
Louis, Thank your for commenting. You express important facts; indeed capital projects can generate the return needed to cover cost of capital and indeed those projects all come to an end. You express it about as simply as it can be stated when you write “as long as you borrow, the interest needs to be paid.” That surely emphasizes the need for efficient, responsible and active debt management. My conservative bent wants to see sufficient assets to pay off the debt itself if circumstances arise making it necessary to do so. All the best to you.
Paul