January 2019 Data Update 7: Debt, neither poison nor nectar!

Debt is a hot button issue, viewed as destructive to businesses by some at one end of the spectrum and an easy value creator by some at the other. The truth, as is usually the case, falls in the middle. In this post, I will look not only at how debt loads vary across companies, regions and industries, but also at how they have changed over the last year. That is because last year should have been a consequential one for financial leverage, especially for US companies, since the corporate tax rate was reduced from close to 40% to approximately 25%. I will also put leases under the microscope, converting lease commitments to debt, as I have been doing for close to two decades, and look at the effect on  profit margins and returns, offering a precursor to changes in 2019, when both IFRS and GAAP will finally do the right thing, and start treating leases as debt.

The Debt Trade Off

Debt is neither an unmixed good nor an unmitigated disaster. In fact, there are good and bad reasons for companies to borrow money, to fund operations, and in this section, I will look at the trade off, and look at the implications for what types of businesses should be the biggest users of debt, and which ones, the smallest.

The Pluses and Minuses

There are only two ways you can raise capital to fund a business. One is to use owner funds, which can of course range from personal savings in a small start up to issuing shares to the market, for a public company. The other is to borrow money, again ranging from a loan from a family member or friend to bank debt to corporate bonds. The debt equity trade off then boils down to what debt brings to the process, relative to equity, in both good and bad ways.

The two big elements driving whether a company should borrow money are the tax code, and how heavily it is tilted towards debt, on the good side and the increased exposure to default and distress, that it also creates, on the bad side. Simply put, companies with stable and predictable earnings streams operating in countries, with high corporate tax rates should borrow more money than companies with unstable earnings or which operate in countries that either have low tax rates or do not allow for interest tax deductions. For financial service firms, the decision on debt is more complex, since debt is less source of capital and more raw material to a bank. As a consequence, I will look at only non-financial service firms in this post, but I plan to do a post dedicate to just financial service firms.

US Tax Reform - Effect on Debt

If one of the key drivers of how much you borrow is the corporate tax code, last year was an opportunity to see this force in action, at least in the US. At the start of 2018, the US tax code was changed in two ways that should have affected the tax benefits of debt:

1. The federal corporate tax rate was lowered from 35% to 21%. Adding state and local taxes to this, the overall corporate tax rate dropped from close to 40% to about 25%.
2. Restrictions were put on the deductibility of interest expenses, with amounts exceeding 30% of taxable income no longer receiving the tax benefit.

Since there were no significant changes to bankruptcy laws or costs, these tax code changes make debt less attractive, relative to equity, for all US companies. In fact, as I argued in this post at the start of 2018, if US companies are weighing the pros and cons correctly, they should have reduced their debt exposure during the course of 2018.

While I have data only through through the end of the third quarter of 2018, I look at the change in total debt, both gross and net, at non-financial service US companies, over the year (by comparing to the debt at the end of the third quarter of 2017).

Download debt change, by industry

In the aggregate, US non-financial service companies did not reduce debt, but instead added $434 billion to their debt load, increasing their total debt from $6,931 billion to $7,365 billion between September 2017 and September 2018. That represented only a 6.26% increase over the year, and was accompanied by a decline in debt as a percent of market capitalization, but that increase is still surprising, given the drop in the marginal tax rate and the ensuing loss of tax benefits from borrowing. There are three possible explanations:

1. Inertia: One of the strongest forces in corporate finance is inertia, where companies continue to do what they have always done, even when the reasons for doing so have long since disappeared. It is possible that it will be years before companies wake up to the changed tax environment and start borrowing less.
2. Uncertainty about future tax rates: It is also possible that companies view the current tax code as a temporary phase and that the drop in corporate tax rates will be reversed by future administrations.
3. Illusory and Transient Benefits: Many companies perceive benefits in debt that I term illusory, because they create value, only if you ignore the full consequences of borrowing. I have captured these illusory benefits in the table below: Put simply, the notion that debt will lower your cost of capital, just because it is lower than your cost of equity, is widely held, but just not true, and while using debt will generally increase your return on equity, it will also proportionately increase your cost of equity.
   

I will continue tracking debt levels through the coming years, and assuming no bounce back in corporate tax rates, we should get confirmation as to whether the tax hypothesis holds.

Debt: Definition

The tax law changed the dynamics of the debt/equity tradeoff, but there is an accounting change coming this year, which will have a significant impact on the debt that you see reported on corporate balance sheets around the world, and since this is the debt that most companies and data services use in measuring financial leverage. Specifically, accountants and their rule writers are finally going to come to their senses and plan to start treating lease commitments as debt, plugging what I have always believed is the biggest source of off balance sheet debt.

Debt: Definition

In my financing construct for a business, I argue that there are two ways that a business, debt (bank loans, corporate bonds) and equity (owner's funds), but to get a sense of how the two sources of capital vary, I looked at the differences:

Specifically, there are two characteristics that set debt apart from equity. The first is that debt creates a contractual or fixed claim that the firm is obligated to meet, in good and bad times, whereas equity gives rise to a residual claim, where the firm has the flexibility not to make any payments, in bad times. The second is that with debt, a failure to meet a contractual commitment, will lead to a loss of control of the firm and perhaps default, whereas with equity, a failure to meet an expected commitment (like paying dividends) can lead to a drop in market value but not to distress. Finally, in liquidation, debt holders get first claim on the assets and equity gets whatever, if any, is left over. Using this definition of debt, we can navigate through a balance sheet and work out what should be included in debt and what should not. If the defining features for debt are contractual commitments, with a loss of control and default flowing from a failure to meet them, it follows that all interest bearing debt, short term as well as long term, bank loans and corporate bonds, are debt. Staying on the balance sheet, though, there are items that fall in a gray area:

1. Accounts Payable and Supplier Credit:  There can be no denying that a company has to pay back supplier credit and honor its accounts payable, to be a continuing business, but these liabilities often have no explicit interest costs. That said, the notion that they are free is misplaced, since they come with an implicit cost. To make use of supplier credit, for instance, you have to give up discounts that you could have obtained if you paid on delivery. The bottom line in valuation and corporate finance is simple. If you can estimate these implicit expenses (discounts lost) and treat them as actual interest expenses, thus altering your operating income and net income, you can treat these items as debt. If you find that task impossible or onerous, since it is often difficult to back out of financial reports, you should not consider these items debt, but instead include them as working capital (which affects cash flows).
2. Underfunded Pension and Health Care Obligations: Accounting rules around the world have moved towards requiring companies to report whether their defined-benefit pension plans or health care obligations are underfunded, and to show that underfunding as a liability on balance sheets. In some countries, this disclosure comes with legal consequences, where the company has to set aside funds to cover these obligations, akin to debt payments, and if this is the case, they should be treated as debt. In much of the world, including the United States, the disclosure is more for informational purposes and while companies are encouraged to cover them, there is no legal obligation that follows. In these cases, you should not consider these underfunded obligations to be debt, though you may still net them out of firm value to get to equity value.

The table below provides the breakdown of debt for non-financial service companies around the world.

Debt Details, by Industry (US)

As you browse this table, please keep in mind that disclosure on the details of debt varies widely across companies, and this table cannot plug in holes created by non-disclosure. To the extent that company disclosures are complete, you can see that there are differences in debt type across regions, with a greater reliance on short term debt in Asia, a higher percent of unsecured and fixed rate debt in Japan and more variable rate, secured debt in Africa, India and Latin America than in Europe or the US. You can get the debt details, by industry, for regional breakdowns at the link at the end of this post.

Debt Load: Balance Sheet Debt
Using all interest bearing debt as debt in looking at companies, we can raise and answer fundamental questions about leverage at companies. Broadly speaking, the debt load at a company can be scaled to either the value of the company or to its earnings and cash flows. Both measures are useful, though they measure different aspects of debt load:

a. Debt and Value
Earlier, I noted that there are two ways you can fund a business, debt and equity, and a logical measure of financial leverage that follows is to look at how much debt a firm uses, relative to its equity. That said, there are two competing measures of value, and especially for equity, the divergence can be wide.

• The first is the book value, which is the accountant's estimate of how much a business and its equity are worth. While value investors attach significant weight to this number, it reflects all of the weaknesses that accounting brings to the table, a failure to adjust for time value of money, an unwillingness to consider the value for current market conditions and an inability to deal with investments in intangible assets. 
• The second is market value, which is the market's estimate, with all of the pluses and minuses that go with that value. It is updated constantly, with no artificial lines drawn between tangible and intangible assets, but it is also volatile, and reflects the pricing game that sometimes can lead prices away from intrinsic value.

In the graph below, I look at debt as a percent of capital, first using book values for debt and equity, and next using market value.

Debt ratios, by industry (US)

In the table below, I break out debt as a percent of overall value (debt + equity) using both book value and market value numbers, and look at the distribution of these ratios globally:

Embedded in the chart is a regional breakdown of debt ratios, and even with these simple measures of debt loads, you can see how someone with a strong  prior point of view on debt, pro or con, can find a number to back that view. Thus, if you want to argue as some have that the Fed (which is blamed for almost everything that happens under the sun), low interest rates and stock buybacks have led US companies to become over levered, you will undoubtedly point to book debt ratios to make your case. In contrast, if you have a more sanguine view of financial leverage in the US, you will point to market debt ratios and perhaps to the earnings and cash flow ratios that I will report in the next section. On this debate, at least, I think that those who use book value ratios to make their case hold a weak hand, since book values, at least in the US and for almost every sector other than financial, have lost relevance as measures of anything, other than accounting ineptitude.

b. Debt and Earnings/Cashflows

Debt creates contractual obligations in the form of interest and principal payments, and these payments have to be covered by earnings and cash flows. Thus, it is sensible to measure how much buffer, or how little, a firm has by scaling debt payments to earnings and cash flows, and here are two measures:

• Debt to EBITDA: It is true that EBITDA is an intermediate cash flow, not a final one, since you still have to pay taxes and invest in growth, before you get a residual cash flow. That said, it is a proxy for how much cash flow is being generated by existing investments, and dividing the total debt by EBITDA is a measure of overall debt load, with lower numbers translating into less onerous loads.
• Interest Coverage Ratio: Dividing the operating income (EBIT) by interest expenses, gives us a different measure of safety, one that is more immediately tied to default risk and cost of debt than debt to EBITDA. Firms that generate substantial operating income, relative to interest expenses, are safer, other things remaining equal, than firms that operate with lower interest coverage ratios. 

In the table below, I look at the distributions of both these numbers, again broken down by region of the world:

Debt ratios, by industry (US)

Again, the story you tell can be very different, based upon which number you look at. Chinese companies have the most debt in the world, if you define debt as gross debt, but look close to average, when you look at net debt. Indian companies look lightly levered, if you look at Debt to EBITDA multiples, but have the most exposure to debt, if you use interest coverage ratios to measure debt load.

Operating Leases: The Accounting Netherworld

Going back to the definition of debt as financing that comes with contractually set obligations, where failure to meet these obligations can lead to loss of control and default, it is clear that focusing on only the balance sheet (as we have so far) is dangerous, since there are other claims that companies create that meet these conditions. Consider lease agreements, where a retailer or a restaurant business enters into a multi-year agreement to make lease payments, in return for using a store front or building. The lease payments are clearly set out by contract, and failing to make these payments will lead to loss of that site, and the income from it. You can argue that leases providing more flexibility that a bank loan and that defaulting on a lease is less onerous, because the claims are against a specific location and not the business, but those are arguments about whether leases are more like unsecured debt than secured debt, and not whether leases should be treated as debt. For much of accounting history, though, accountants have followed a different path, treating only a small subset of leases as debt and bringing them on to the balance sheet as capital leases, while allowing the bulk of lease expenses as operating expenses and ignoring future lease commitments on balance sheets. The only consolation prize is that both IFRS and GAAP have required companies to show these lease commitments as footnotes to balance sheets.

In my experience, waiting for accountants to do the right thing will leave you twisting in the wind, since it seems to take decades for common sense to prevail. Consequently, I have been treating leases as debt for more than three decades in valuation, and the process for doing so is neither complicated nor novel. In fact, it is the same process that accountants use right now with capital leases and it involves the following steps:

1. Estimate a current cost of borrowing or pre-tax cost of debt for the company today, given its default risk and current interest rates (and default spreads).
2. Starting with the lease commitment table that is included in the footnotes today, discount each lease commitment back to today, using the pre-tax cost of debt as your discount rate (since the lease commitments are pre-tax). Most companies provide only a lump-sum value for commitments after year 5, and while you can act as if this entire amount will come due in year 6, it makes more sense to convert it into an annuity, before discounting.
3. The sum total of the present value of lease commitments will be the lease debt that will now show up on your balance sheet, but to keep the balance sheet balanced, you will have to create a counter asset. 
4. To the extent that the accounting has treated the current year's lease expense as an operating expense, you have to recompute the operating income, reflecting your treatment of leases as debt:

Adjusted Operating Income = Stated Operating Income + Current year's lease expense - Depreciation on the leased asset

Capitalizing leases will have large consequences for not just debt ratios at companies (pushing them for companies with significant lease commitments) but also for operating profitability measures (like operating margin) and returns on invested capital (since both operating income and invested capital will be changed). The effects on net margin and return on equity should either be much smaller or non-existent, because equity income is after both operating and capital expenses, and moving leases from one grouping to another has muted consequences. In the table below, I report on debt ratio, operating margin and return on capital. before and after the lease adjustment :

Lease Effect, by Industry, for US

You can download the effects, by industry, for different regions, by using the links at the bottom of this post.  Keep in mind, though, that there are parts of the world where lease commitments, though they exist, are not disclosed in financial statements, and as a consequence, I will understate the else effect, While the effect is modest across all companies, the lease effect is larger in sectors that use leases liberally in operations, and to see which sectors are most and least affected, I looked at the ten   sectors, among US companies, and not counting financial service firms, that saw the biggest percentage increases in debt ratios and the ten sectors that saw the smallest in the table below:

Lease Effect, by Industry, for US

Note that there are a large number of retail groupings that rank among the most affected sectors, though a few technology companies also make the cut. As I noted at the start of this post, this year will be a consequential one, since both GAAP and IFRS will start requiring companies to capitalize leases and showing them as debt. While I applaud the dawning of sanity, there are many investors (and equity research analysts) who are convinced that this step will be catastrophic for companies in lease-heavy sectors, since it will be uncover how levered they are. I am less concerned, because markets, unlike accountants, have not been in denial for decades and market prices, for the most part and for most companies, already reflect the reality that leases are debt. 

Debt: Final Thoughts

One of the biggest impediments to any rational discussion of debt's place in capital is the emotional baggage that we bring to that discussion. Debt is neither poison, as some detractors claim it to be, nor is a nectar, as its biggest promoters describe it. It is a source of capital that comes with fixed commitments and the risk of default, good for some companies and bad for others, and when it does create value, it is because the tax code it tilted towards it. It is true that some companies and investors, especially those playing the leverage game, over estimate its benefits and under estimate its side costs, but they will learn their lessons the hard way. It is also true that other companies and investors, in the name of prudence, think that less debt is always better than more debt, and no debt is optimal, and they too are leaving money on the table, by being too conservative.

YouTube Video


Datasets

1. Debt Change, by Industry Group for US companies, in 2019
2. Debt Details, by Industry Group in 2019 for US, Europe, Emerging Markets, Japan, Australia & Canada, India and China
3. Debt Ratios, by Industry Group in 2019 for US, Europe, Emerging Markets, Japan, Australia & Canada, India and China
4. Lease Capitalization Effects, by Industry Group in 2019 for US, Europe, Emerging Markets, Japan, Australia & Canada, India and China

Papers

1. Leases, Debt and Value (SSRN paper on how to capitalize leases and how it might affect value)

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Read More

January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies. 

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

via chartsbin.com
2. Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT). 

There are two other provisions in the tax code which will also indirectly affect the debt trade off.

1. Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.
2. Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.

All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing. 

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:

Disney Capital Structure Spreadsheet

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.

Download spreadsheets: Disney, Facebook & Ford

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt. 

For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios. 

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

Sub Group	Debt/Capital (Book)	Debt/Capital (Market)	Net Debt/ Capital (Book)	Net Debt/ Capital (Market)	Debt/EBITDA
Africa and Middle East	45.23%	34.00%	30.27%	21.31%	5.99
Australia & NZ	61.66%	43.48%	57.82%	39.60%	8.57
Canada	55.35%	42.42%	52.46%	39.60%	7.16
China	51.63%	39.34%	41.83%	30.40%	8.52
EU & Environs	60.75%	47.17%	53.68%	40.07%	7.78
Eastern Europe & Russia	31.02%	38.05%	21.35%	27.05%	2.47
India	54.89%	20.85%	50.58%	18.15%	3.92
Japan	56.16%	49.11%	27.64%	22.35%	7.61
Latin America & Caribbean	51.67%	40.01%	46.23%	34.90%	5.74
Small Asia	44.04%	34.76%	36.01%	27.59%	4.54
UK	63.74%	46.39%	53.68%	36.33%	7.94
United States	64.06%	37.11%	60.86%	33.99%	7.09

The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.

Download full sector spreadsheet

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them. 

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:

1. Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.
2. Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.
3. Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them. 

As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.

Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.

YouTube Video


Datasets

1. Debt Ratios by Sector, US (January 2018)
2. Debt Ratios by Sector, Global (January 2018)

Spreadsheets

1. Capital Structure Optimizing Spreadsheet (with 2017 US Tax Code changes built in) (with YouTube guide to using this spreadsheet)
2. Disney Optimal Capital Structure 
3. Facebook Optimal Capital Structure
4. Ford Optimal Capital Structure

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

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January 2017 Data Update 8: The Dark and Light Sides of Debt

There is no aspect of corporate finance where morality plays a bigger role than  the decision of how much to borrow. That should come as no surprise. For generations, almost every religion has inveighed against debt, with some seeking outright bans and others strongly urging followers to "neither a borrower nor a lender be", and perhaps with good reason. History is filled with instances of human beings, caught up in the mood of the moment, borrowing money and then finding themselves destitute in bad times. That said, there is no denying that the decision of whether to borrow money, and if so how much to borrow, has become a critical part of running a business.

The trade off on debt

In corporate finance, the discussion of debt begins with an examination of the trade offs on using debt, instead of equity, to finance operations. I have described debt as a double-edged sword before, and running out of analogies, I am going to draw on Star Wars framing, and talk about the light side (benefits) of debt and the dark side (costs) of debt. In the course of the discussion, I want to separate the illusory benefits and costs of debt from the real benefits and costs, partly because I see them mixed up in practice all the time.

In terms of the real factors that drive the trade off, debt creates two benefits. The biggest comes from the tilt in the tax code, which allows interest expenses to be tax deductible and cash flows to equity to be not. The secondary benefit is that debt can operate as a disciplinary mechanism, with the discipline of having to make debt payments restraining managers from taking truly abysmal projects. These benefits have to be offset against two big costs, the first and biggest being the increased likelihood of distress and the second being the potential for disagreements between lenders and equity investors about the future of the firm (and how it plays out as debt covenants). All of these factors show up in the cash flows and risk assessment of a business. There are however illusory factors that can be distracting. On the benefit side, there are some who argue that debt is good because it can push up your return on equity or point to the fact that the cost of debt is lower than the cost of equity. Both statements are generally right, but the flaw in reasoning in both is that they assume that as you borrow more money, your cost of equity will remain unchanged, and it will not. In fact, in the absence of debt and distress, the positive and negative effects will offset each other, leading to no value change. On the cost side, debt detractors will note that the interest expenses associated with debt will lower net income, ignoring the fact that the lower net income is now being earned on a lower equity base. If the argument is that debt will increase default risk and the cost of debt, it is worth pointing out that even at the higher cost, debt is still cheaper than equity. Finally, there are transient factors that come from market frictions, where if your equity is mis-priced or the interest rate on your debt is set too low or high (given your default risk), you (as the company) may take advantage of the friction, using more debt if equity is under priced and debt carries too low an interest rate and less debt if equity is over priced and debt carries too high a rate. This, of course, will require CFOs of companies to embark on that most dangerous of expeditions, of judging market assessments of their value and risk. The picture below brings together all of the elements:

As we debate why companies borrow money and how it affects their value, it is good to be clear eyed about how debt changes value. It is almost entirely because of the tax benefit that it is endowed with, and if you take that tax benefit away, the reasons for borrowing quickly dissipate.

The Cross Sectional Distribution 

Before we embark on an examination of debt loads across companies, let's start by looking at three different measures of financial leverage:

1. Debt to Capital = Debt/ (Debt + Equity): This is a measure of how much of the capital in a company comes from debt. It can be measured as accountants see value (with book values for debt and equity) or as the market sees it (with market values for debt and equity).
2. Debt to Equity = Debt/Equity: This is a close variant of debt to capital, with debt stated as a percent of equity, again in book value or market value terms.
3. Debt to EBITDA = Debt/EBITDA: This measures how much debt a company has relative to the cash it generates from operations, before taxes and capital expenditures.

In computing my total debt for the 42,668 companies in my sample, I include all interest bearing debt (short term, as well as long term) as well as the present value of lease commitments (which I treat as debt, and which accountants will start treating as debt in 2018 or 2019).  I will start by looking at the distribution of debt to capital ratios, in both book and market terms, across all companies:

A large percentage of firms, more than 25% in the US and almost 20% globally, have no debt. Regionally, on a market debt to capital ratio, Eastern Europe(with Russia) and Latin America are the most highly levered regions of the world, but in terms of debt as a multiple of EBITDA, Canadian and Chinese companies have the highest debt burden.

I follow up by looking at debt to capital ratios for companies, by country, in the picture below and the statistics for all four measures of leverage in this spreadsheet.

Link to live map

Latin America and Eastern Europe remain the most indebted region in the world, with almost every country in each region having debt ratios of 30% or higher in market value terms and often 50% or higher in book value terms. While some of this can be attributed to the drop in commodity prices over the last few years, I think that one reason is that many Latin American companies are hooked on a combination of high (and often unsustainable) dividends and a desire for control (manifested in an unwillingness to dilute equity ownership). The same factors explain why many Middle Eastern companies, where there is no tax benefit from debt, continue to borrow money.

Industry Differences

You would expect companies in different sectors to have very different policies on financial leverage, and most of the differences have to do with where they fall on the debt trade off. In the table below, I list the most highly levered and lightly levered non-financial service sectors in the United States, in terms of market debt to capital ratios.

Spreadsheet with debt ratios, by sector

There are few surprises on this list, as you see technology sectors (software, online retail, semiconductor, semiconductor equipment and electronics) on the least-levered list and capital intensive sectors (power, trucking, telecom) on the most-levered list. It is interesting that integrated oil/gas companies are among the least levered sectors but oil/gas distribution is on the most levered list. If you want to see the full list of industries, not just for the United States but also for other regions of the world, try this spreadsheet.

Closing

In my earlier post on taxes, I noted that 2017 is likely to be a year of change, at least for the US tax code and almost every version of tax reform that is being talked about will reduce the marginal tax rate and therefore the tax benefits of debt. In fact, there are some versions where the entire tax benefit of debt will be removed. While I believe that this will be healthier in the long term for businesses, it will be a seismic shift that will have massive effects not just on corporate borrowing but on the corporate bond market. I am not sure that we (as investors and companies) are ready for that big a change. So, small steps way from the status quo, which is skewed strongly towards borrowers, may be all that you can expect to see!

YouTube Video

Spreadsheets

1. Capital Structure Optimizer
2. APV Spreadsheet

Datasets

1. Debt Ratios, by country
2. Debt Ratios, by industry

Data 2017 Posts

1. Data Update 1: The Promise and Perils of Big Data
2. Data Update 2: The Resilience of US Equities
3. Data Update 3: Cracking the Currency Code - January 2017
4. Data Update 4: Country Risk and Pricing, January 2017
5. Data Update 5: A Taxing Year Ahead?
6. Data Update 6: The Cost of Capital in January 2017
7. Data Update 7: Profitability, Excess Returns and Corporate Governance- January 2017
8. Data Update 8: The Debt Trade off in January 2017
9. Data Update 9: Dividends and Buybacks in 2017
10. Data Update 10: The Pricing Game

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January 2016 Data Update 6: Debt, the double edged sword!

In corporate finance, the decision on whether to borrow money, and if so, how much has divided both practitioners and theorists for as long as the question has been debated. Corporate finance, as a discipline, had its beginnings in Merton Miller and Franco Modigliani's classic paper on the irrelevance of capital structure. Since then, theorists have finessed the model, added real life concerns and come to the unsurprising conclusion that there is no one optimal solution that holds across companies. At the same time, practitioners have also diverged, with the more conservative ones (managers and investors) arguing that debt brings more pain than gain and that you should therefore borrow as little as possible, and the most aggressive players positing that you cannot borrow too much.

The Trade off on debt

The benefits of debt, for better or worse, are embedded in the tax code, which in much of the world favors borrowers. Specifically, a company that borrows money is allowed to deduct interest expenses before paying taxes, whereas one that is equity funded has to pay dividends out of after-tax earnings. This, of course, makes it hypocritical of politicians to lecture any one on too much debt, but then again, hypocrisy is par for the course in politics. A secondary benefit of debt is that it can make managers in mature, cash-rich companies a little more disciplined in their project choices, since taking bad projects, when you have debt, creates more pain (for the managers) than taking that same projects, when you are an all equity funded company.

On the other side of the ledger, debt does come with costs. The first and most obvious one is that it increases the chance of default, as failure to make debt payments can lead to financial distress and bankruptcy. The other is that borrowing money does create the potential for conflict between stockholders (who seek upside) and lenders (who want to avoid downside), which leads to the latter trying to protect themselves by writing in covenants and/or charging higher interest rates.

Pluses of Debt	Minuses of Debt
1. Tax Benefit: Interest expenses on debt are tax deductible but cash flows to equity are generally not. The implication is that the higher the marginal tax rate, the greater the benefits of debt.	1. Expected Bankruptcy Cost: The expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt. The latter includes both direct and indirect costs. The probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses.
2. Added Discipline: Borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. The greater the separation between managers and stockholders, the greater the benefits of using debt.	2. Agency Costs: Actions that benefit equity investors may hurt lenders. The greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants). Businesses where lenders can monitor/control how their money is being used can borrow more than businesses where this is difficult to do.

In the Miller-Modigliani world, which is one without taxes, bankruptcies or agency problems (managers do what's best for stockholders and equity investors are honest with lenders), debt has no costs and benefits, and is thus irrelevant. In the world that I live in, and I think you do too, where taxes not only exist but often drive big decisions, default is a clear and ever-present danger and conflicts of interests (between managers and stockholders, stockholders and lenders) abound, some companies borrow too much and some borrow too little.

The Cross Sectional Differences

Looking at the trade off, it is clear that 2015 tilted more towards the minus side than plus side of the equation for debt, as the Chinese slowdown and the commodity price meltdown created both geographic and sector hot spots of default risk. As in prior years, I started by looking at the distribution of debt ratios across global companies, in both book and market terms:

Debt to capital (book) = Total Debt/ (Total Debt + Book Equity)

Debt to capital (market) = Total Debt/ (Total Debt + Market Equity)

In keeping with my argument that all lease commitments should be considered debt, notwithstanding accounting foot dragging on the topic, I include the present value of lease commitments as debt, though I am hamstrung by the absence of information in some markets. I also compute net debt ratios, where I net cash out against debt, for all companies:

Damodaran Online

While debt ratios provide one measure of the debt burden at companies, there are two other measures that are more closely tied to companies getting into financial trouble. The first is the multiple of debt to EBITDA, with higher values indicative of a high debt burden and the other is the multiple of operating income to interest expenses (interest coverage ratio), with lower values indicating high debt loads. In 2015, the distribution of global companies on each of these measures is shown below:

By itself, there is little that you can read into this graph, other than the fact that there are some companies that are in danger, with earnings and cash flows stretched to make debt payments, but that is a conclusion you would make in any year.

The Industry Divide

To dig a little deeper into where the biggest clusters of companies over burdened with debt are, I broke companies down by industry and computed debt ratios (debt to capital and debt to EBITDA) by sector. You can download the entire industry data set by clicking here, but here are the 15 sectors with the most debt (not counting financial service firms), in January 2016.

Damodaran Online, January 2016

There is a preponderance of real estate businesses on this list, reflecting the history of highly levered games played in that sector. There are quite a few heavy investment businesses, including steel, autos, construction shipbuilding, on this list. Surprisingly, there are only two commodity groups (oil and coal) on this section, oil/gas distribution, but it is likely that as 2016 rolls on, there will be more commodity sectors show up, as earnings lag commodity price drops.

In contrast, the following are the most lightly levered sectors as of January 2016.

Damodaran Online, January 2016

The debt trade off that I described in the first section provides some insight into why companies in these sectors borrow less. Notice that the technology-related sectors dominate this list, reflecting the higher uncertainty they face about future earnings. There are a few surprises, including shoes, household products and perhaps even pharmaceutical companies, but at least with drug companies, I would not be surprised to see debt ratios push up in the future, as they face a changed landscape.

The Regional Divides

If the China slow-down and the commodity pricing collapse were the big negative news stories of 2015, it stands to reason that the regions most exposed to these risks should also have the most companies in debt trouble. The regional averages as of January 2016 are listed below:

Damodaran Online, Data Update of 41,889 companies in January 2016

The measure that is most closely tied to the debt burden is the Debt to EBITDA number and that is what I will focus on in my comparisons. Not surprisingly, Australia, a country with a disproportionately large number of natural resource companies, tops the list and it is followed closely by the EU and the UK.  Canada has the highest percentage of money-losing companies in the world, again due to its natural resource exposure. The companies listed in Eastern Europe and Russia have the least debt, though that may be due as much to the inability to access debt markets as it is to uncertainty about the future. With Chinese companies, there is a stark divide between mainland Chinese companies that borrow almost 2.5 times more than their Hong Kong counterparts. If you are interested in debt ratios in individual countries, you can see my global heat map below or download the datasets with the numbers.

via chartsbin.com

If the biggest reason for companies sliding into trouble in 2015 were China and Commodities, the first three weeks of 2016 have clearly made the dangers ever more present. As oil prices continue to drop, with no bottom in sight, and the bad news on the Chinese economy continue to come out in dribs and drabs, the regions and sectors most exposed to these risks will continue to see defaults and bankruptcies. These, in turn, will create ripples that initially affect the banks that have lent money to these companies but will also continue to push up default spreads (and costs of debt) for all firms. 

The Bottom Line

Debt is a double edged sword, where as you, as the borrower, wield one edge against the tax code and slice your taxes, the other edge, just as sharp, is turned against you and can hurt you, in the event of a downturn. In good times, companies that borrow reap the benefits of debt, slashing taxes paid and getting rewarded with high values by investors, who are just as caught up in the mood of the moment. In bad times, which inevitably follow, that debt turns against companies, pushing them into financial distress and perhaps putting an end to their existence as ongoing businesses.  One constraint that I will bring into my own investments decisions in 2016 is a greater awareness of financial leverage, where in addition to valuing businesses as going concerns, I will also look at how much debt they owe. I will not reflexively avoid companies that have borrowed substantial amounts, but I will have to realistically assess how much this debt exposes them to failure risk, before I pull the "buy" trigger.

Datasets

1. Debt Ratios, by sector (January 2016)
2. Debt Ratios, by country (January 2016)

Data Update Posts

1. January 2016 Data Update 1: The US Equity Market 
2. January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies 
3. January 2016 Data Update 3: Country Risk and Pricing
4. January 2016 Data Update 4: Costs of Equity and Capital
5. January 2016 Data Update 5: Investment Returns and Profitability
6. January 2016 Data Update 6: Capital Structure
7. January 2016 Data Update 7: Dividend Policy
8. January 2016  Data Update 8: Pricing, with an end of month update

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