More research must be done as to why firms become hooked to high debt. As they say about addiction, admitting you have a problem is the first step towards solving it
The recent suicide by Café Coffee Day owner jolted every coffee lover in the country and brought to the fore the grim reality that high debt can be dangerous for a company. A business is said to be overleveraged when it carries too much debt and is unable to make interest payments on loans and meet other expenses.
Overleveraged companies are often unable to pay operating expenses because of the burden brought on by debt in the form of interest payments and principal repayments. Overleveraging can sometimes lead to a downward financial spiral where the company cannot generate enough revenue to make the debt payments and pay its usual operating expenses. This leads to the company having to borrow more to stay in operation, and the problem gets worse. This spiral usually ends when the company closes its doors or files for bankruptcy protection.
A less leveraged company can be better positioned to sustain drops in revenue because they do not have the same expensive debt-related burden on their cash flow. Businesses that borrow money to add to a product line, expand internationally, or upgrade their facilities are often better able to offset the risk they take on when borrowing. Leverage can be measured by financial leverage ratios, sometimes called equity or debt ratios, which measure the value of equity in a company by analyzing its overall debt picture. These ratios either compare debt or equity to assets as well as shares outstanding to measure the true value of the equity in a business.
This shows how much of the company assets belong to the shareholders rather than creditors. When shareholders own a majority of the assets, the company is said to be less leveraged. When creditors own a majority of the assets, the company is considered highly leveraged. All of these measurements are important for investors to understand how risky the capital structure of a company is and if it is worth investing in.
The most common financial leverage ratios are debt ratios, debt-equity ratios and equity ratios. Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all its liabilities. The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing, i.e., bank loans, is being used than investor financing, i.e., shareholders. The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed by the owner’s investments by comparing the total equity in the company to the total assets.
In fact, some years ago, a team of financial scholars at Stanford Graduate School of Business and at Germany’s Max Planck Institute studied banks and found that they have become “addicted” to increasing their debt levels steadily. According to them, “leverage begets leverage”. However, it was further analysed that other corporations have become addicted to debt, even when it reduces the total value of the enterprise. Once a company begins to take on debt, they say, the leverage becomes almost “irreversible.” Shareholders will generally oppose measures that reduce debt and support moves to increase it whenever the opportunity arises.
According to Paul Pfleiderer, a professor of finance at Stanford, taking leverage is like eating potato chips. One cannot stick to the commitment of eating just a few chips. So, if one cannot stop after eating just one chip, one might be better off not eating them at all. The authors argue that since reducing debt entails a transfer of risk – and wealth – from shareholders to creditors, there is a clear disincentive for shareholders to cut back on borrowing. If a company buys back its bonds, for example, bondholders will demand a premium above the current market price for those bonds. That’s because bondholders will insist that the buyback price reflect the fact that the remaining debt will be at less risk of default.
In other words, bondholders get all the benefits of debt reduction and shareholders have to foot the cost upfront. Government tax policy makes companies even more biased toward higher debt, because it allows companies to deduct interest payments from their taxable income. In theory, creditors can protect themselves by insisting on contracts or “covenants” that restrict a company’s ability to increase its leverage in the future. Among other things, covenants can restrict a company from selling additional bonds or making big payouts to shareholders, which reduce the company’s equity. In practice, the authors argue, covenants are difficult to enforce. Most covenants give companies at least some discretion to take on more debt, because companies need flexibility in dealing with new opportunities and problems. On top of that, the creditors are often dispersed and unable to take a unified position.
The most obvious risk of high debt is the increased danger of falling into financial distress or even bankruptcy. But on the other hand, rising leverage can also make companies reluctant to invest in promising new projects. That’s because part of the increase in value generated by an investment would flow not to the shareholders but to the creditors, because their bonds and loans would become more secure. Corporate boards take a hard new look at how much they compensate management through stock options and other grants of equity in the company. The more money managers earn from grants of stock and options, rather than from their salaries, the more they will align their self-interest with shareholders rather than creditors
As bad as it may seem, at some point, almost all businesses must take out loans. Debt financing can be attractive to business owners because banks won’t dictate how they should spend the money and they don’t have to split up company ownership. Highly leveraged companies are very sensitive to economic declines and at higher risk for bankruptcy. There are several problems of a highly leveraged company. First, the lenders require borrowers to pay back their loan in a timely manner. This becomes a problem for fledgling companies that borrow money for projects with long-term returns. If payments come due before the company starts seeing returns, loan repayments can be a crippling expense. Paying back the loan on a regular basis means less money to finance operations and invest in growth opportunities.
Second, substantial loan payments can easily cripple a highly leveraged company. A company doesn’t have an obligation to repay capital from equity sources. However, banks and lenders have top seniority when it comes to repayment in the event of a bankruptcy. This means that lenders will get paid out before anyone else, including the company owner. If the company has a secured loan, the bank can repossess company assets. Depending on the business structure and the terms of the loan, the owner of the company may also be personally liable for the loan repayment.
Third, just like with individual lending, banks scrutinize corporate credit reports before doling out more loans. Banks are unlikely to provide further funding to highly leveraged organizations. Not only are these companies at high risk for bankruptcy, the new lender might not get paid back if the company goes under. Older loans typically carry higher seniority compared to newer loans, so lenders are hesitant to put themselves at the bottom of the list for recouping their investment. In the event a bank does issue a loan, the interest rate will be high enough to account for that increased risk.
Fourth, one of the options a company has to reduce its financial leverage is to increase the amount of equity capital.
However, investors rarely give money to highly leveraged businesses. Investors avoid highly leveraged companies for all the same reasons lenders do, plus they’re the last in line to get repaid. If an investor is willing to invest in a highly leveraged company they’ll expect to receive an especially large percentage of ownership in exchange for their money.
It’s important that further research should be done to shed light on why companies can become hooked to high debt. As they say about other forms of addiction, admitting you have a problem is the first step towards solving it.
(The writer is Assistant Professor, Amity University)
Writer: Hima Bindu Kota
Courtesy: The Pioneer