More than 90% of the companies in the S&P 500 have now reported second-quarter results, and it appears the business-led recovery remains on track—75% have reported earnings above expectations, with a year-over-year growth rate of 38%.*
But despite strong and better-than-expected earnings growth for big publicly traded companies, some pundits bemoan high corporate debt levels and balance sheet leverage. A popular storyline found in the media is that corporate America doesn't have the financial strength to keep fueling the economic recovery.
However, a closer examination of the data reveals corporate America is quite liquid and well capitalized. Here we'll examine US nonfarm, nonfinancial corporations (which we'll simply refer to as "US corporations") through the lens of the Federal Reserve's Q1 Flow of Funds report, applying four common financial measures to corporate America's aggregate balance sheet: the Debt-to-Equity Ratio, the Current Ratio, the Debt-to-EBITDA Leverage ratio, and the Interest Coverage Ratio.
The Debt-to-Equity Ratio
The debt-to-equity ratio helps analysts evaluate the relative portions of debt and equity companies use to finance their assets. A higher ratio signals a higher reliance on debt. The ratio can be applied to US corporations by dividing their total debt by total net worth. The debt-to-equity ratio—illustrated by the gray line in Exhibit 1—now stands at a record high 57%, and is often cited as evidence of strained corporate balance sheets.
However, this figure is misleading in our opinion. The Flow of Funds report calculates "net worth" by valuing real estate at mark-to-market prices—leading to significant volatility in the value of corporate net worth during the recent commercial real estate boom-and-bust. But this doesn't make much sense for most non-financial companies, for which real estate is rarely a short- or even medium-term investment. If a company buys property to build a widget factory, fluctuations in the market value of that real estate have little bearing on the widget-maker's business. As such, many public companies account for their commercial real estate assets at historic or replacement cost rather than market value.
When the debt-to-equity ratio is adjusted to more appropriately account for real estate (land valued at historic cost and structures such as factories valued at the cost of rebuilding them), it's just 52%—well below the high of 58% and slightly less than the 20-year average. Based on this measure, US corporations have less balance sheet leverage than they did for the latter part of the 1980s and most of 1990s.
Exhibit 1: Debt-to-Equity Ratios for US Corporations
Source: Thomson Reuters; Federal Reserve Flow of Funds, Balance Sheet of Nonfarm Nonfinancial Corporate Business
The Current Ratio
The Current Ratio, calculated as Current Assets / Current Liabilities, is a liquidity measure used to evaluate a company's ability to meet its short-term financial obligations. We can calculate a proxy for US corporations with the ratio of total liquid assets to total short-term debt. The higher the ratio, the more liquid US corporations are.
At the end of Q2 2010, US corporations had a current ratio of 51%—the highest on record, as illustrated in Exhibit 2. This not only reflects a 26% year-over-year increase in corporate cash balances—to a record $1.84 trillion—but also a 6% decline in short-term debt, driven by a double-digit reduction in reliance on bank loans. Indeed, US corporations have been tremendously successful at refinancing, with short-term borrowings now constituting just 50% of total debt outstanding—down from 60% at the beginning of the financial crisis.
Exhibit 2: Current Ratio for US Corporations
Source: Thomson Reuters; Federal Reserve Flow of Funds Data, Balance Sheet of Nonfarm Nonfinancial Corporate Business
The Leverage Ratio
The debt-to-EBITDA leverage ratio measures a company's total outstanding debt relative to its earnings before interest, taxes, depreciation and amortization and is a common metric used to evaluate a company's ability to pay down incurred debt. The higher the ratio, the more debt relative to a company's earnings. For US corporations, the aggregate debt-to-EBITDA ratio (with EBITDA approximated by the sum of pre-tax earnings before net interest payments and depreciation) stood at 3.8x as of the end of Q2.
Although this is high relative to recent historical norms—the 20-year average debt-to-EBITDA ratio is 3.4x—it isn't so surprising given the sharp decline in earnings during the downturn. As earnings recover from trough levels, this ratio can be expected to fall significantly—as it has following every recession in the last 50 years. As illustrated in Exhibit 3, it has already fallen from its high of 4.2x, as pre-tax earnings recovered 52.5% year-over-year in the first quarter.
Exhibit 3: Debt/EBITDA Leverage Ratio for US Corporations
Source: Thomson-Reuters; National Bureau of Economic Research; Federal Reserve Flow of Funds Data, Balance Sheet of Nonfarm Nonfinancial Corporate Business; Bureau of Economic Analysis, National Income and Product Accounts
The Interest Coverage Ratio
The interest coverage ratio measures a company's EBITDA relative to its net interest expenses. The ratio is used to evaluate a corporation's ability to service its debt obligations—the higher the ratio, the easier a firm can finance its debt. Broadly applied, this measure shows US corporations have EBITDA totaling 9.2x their aggregate net interest expense—well above the average 8.3x over the last 20 years, despite the fact corporate earnings are still well below their pre-recession peak. Primarily, the high interest coverage ratio reflects low corporate bond yields and US corporations' tremendous success at refinancing at lower rates.
Based on the Dow Jones Aggregate US Corporate Bond Index, corporations were paying an average 4% yield on new bond issuance at the end of the second quarter—close to the lowest rate on record. And corporations have capitalized on this, refinancing $220 billion in short-term debt over the last year with long-term bonds issued at more attractive terms.
Exhibit 4: Interest Coverage Ratio for US Corporations
Source: Thomson Reuters; Federal Reserve Flow of Funds, Balance Sheet of Nonfarm Nonfinancial Corporate Business; Bureau of Economic Analysis, National Income and Product Accounts; Global Financial Data, Dow Jones US Corporate Bond Yield
Conclusion: US Corporations Are Well Capitalized and Enjoy Significant Liquidity
Balance sheet strength only tells one part of the story for individual companies, and it only tells one part of the story for corporate America—there are other important factors investors must also evaluate, such as the prospects for future earnings growth and profitability.
However, based on our evaluation of US corporations, it seems clear concerns about corporate America's balance sheet are misplaced. Companies are enjoying manageable debt levels relative to equity, tremendous access to liquidity, bond yields near record lows, and rapidly recovering earnings—a strong foundation, in our view, for the ongoing business-led recovery.
* Thomson Reuters, This Week in Earnings, 8/13/10