Relationships can be challenging. While some seem to flow naturally and are ever-empowering, others are just the opposite. And then there are those that oscillate between love and hate as the pendulum swings back and forth. This is the type of relationship that many companies have with business debt. Stay away too long, and a company fails to realize the potential leverage that it might bring. Get in too deep, and a company may soon find itself adrift on a sea of heartache. But what is too much debt for a bold business? And how much debt is too little? This is a question that many companies should be asking themselves given the current economic climate. I will try to answer it and also showcase some examples of the good and the bad at leveraging debt.
The Love-Hate Dynamics of Business Debt
It’s not surprising that too much personal or business debt can handcuff opportunities for success. As the 2008 recession highlighted quite well, debt leverage has its limits. But that doesn’t mean that all debt is a bad thing.
For companies that fail to take advantage of debt leveraging, the ability to grow and compete in the marketplace may be significantly constrained. But at the same time, overstepping boundaries of healthy business debt can limit opportunities. This reflects the yin and yang of business debt, which many companies struggle on a regular basis.
When expenses associated with debt financing are low, business debt offers a less costly approach to long-term gains. Assessing a company’s ability to effectively leverage debt is something most investors examine in detail. A company without any debt may be attractive from a liquidity standpoint… but it hardly reflects a desire for the business to grow and compete in a dynamic market setting.
Businesses that poorly assess how much debt is too much can quickly get into trouble. Rising liabilities versus assets can handcuff a business, resulting in other constraints. For example, an excessive business debt may strangle supply chains and access to the materials and equipment needed for operations. Similarly, too much business debt may also prevent a company from taking advantage of a developing market opportunity.
Knowing how much debt is too much and walking the “debt tightrope” is essential for companies in attaining ongoing success.
Today’s Evolving Climate of Business Debt
Over the course of the last decade, some analysts describe today’s debt climate as the perfect storm. For years, the cost of borrowing money has been extremely inexpensive. In an effort to stimulate business growth through borrowing post-recession, the Federal Reserve rate has remained incredibly low. Concurrently, a growing economy fueled by government tax cuts to corporations has made cash more accessible. As a result, companies have taken advantage of business debt, borrowing to advance company growth options. Debt-fueled acquisitions and stock buy-backs have skyrocketed over the last few years.
But times are changing. Recent increases in the Federal Reserve rate mean debt financing will be more expensive. In turn, business expenses will increase for companies that have leveraged debt for growth.
And with future interest rates expected to climb further, this will likely create serious problems for many companies. Those businesses unable to recognize how much debt is too much may soon find themselves in big trouble. In fact, several major corporations are already experiencing such effects.
“[The] massive amount of debt should concern investors as we enter the late innings of a credit cycle in a rising rate environment,” – Andrew Chang, Director of Corporate Ratings, Standard and Poor’s
How Much Debt is Too Much – Crunching the Numbers
For businesses, the way to determine how much debt is too much involves taking a look at some important figures.
As a general rule, companies must have adequate revenue to support debt costs while also covering operations. With this in mind, several financial ratios can be used to help identify how much debt is too much. Common financial ratios to assess debt leverage may include the following:
Debt-to-equity ratio – Simply put, this takes a company’s total liabilities divided by shareholder equity. Ideal values vary based on industry standards, which offer some guide on effective business debt leveraging.
Current ratio – This business debt measure divides a company’s current assets by its current liabilities. Values greater than 1.0 support good liquidity, with values of 2.0 preferred.
Working capital ratio – As the name implies, this figure provides insight into effective debt leverage through current financials. By dividing short-term debt by working capital, businesses can better determine how much debt is too much. This figure should ideally be less than 1.0.
Businesses Leveraging Debt Today – The Good and the Bad
Given the recent enticements for borrowing, many companies have pursued debt leveraging as a means to achieve market growth. But not all necessarily know how much debt is too much in this pursuit. The following highlights some companies that have leveraged business debt well, and some that have not.
Werner Enterprises Inc. – This leader in transportation and logistics has not been shy in taking on new business debt. In fact, its business debt has climbed to $95 million, leaving less than $10 million in cash. But its working capital ratio is above 3.0, with a current ratio of 1.8. Particularly in a capital-heavy industry, Werner appears to have effectively leveraged its business debt, with current revenues exceeding $285 million a year.
Emergen Corporation – Emergen is involved in oil and gas exploration, and the energy sector is quite competitive. Over the course of the last few years, Emergen’s debt-equity ratio has averaged 0.72. This means its liabilities are less than shareholder equity. Likewise, Emergen’s current ratio is 1.75, which also suggests strong liquidity. These figures, combined with annual earnings growth of 23.7 percent, showcase effective debt leveraging.
Amedysis – As a leader in health and hospice services, Amedysis has also been recognized as effectively leveraging business debt. The company’s growth has exceeded 16.5% for the last year. Likewise, Amedysis has a low debt-to-equity ratio of 0.14. Though its long-term debt-to-capital equity is 12.1, the industry average is nearly 55. Amedysis looks to be in strong financial and market shape as a result of their business debt strategies.
General Electric – Recent dividends paid to GE shareholders were roughly a single cent, with reported quarterly losses being over $22.8 billion. Excessive business debt plays a significant role in GE ’s, decline, which is roughly $115 million. Losing over 45% of the company’s value this year, GE’s debt-to-equity ratio is far from ideal. As a result, the company is having to sell off numerous assets with hopes of restructuring its current debt situation.
Campbell Soup Company – As part of the acquisition wave, Campbell Soup borrowed $6 billion to purchase Snyder’s Lance Inc. Unfortunately, this placed its business debt in excess of $10 billion. This naturally resulted in a markedly high debt-to-equity ratio for the company. And Campbell Soup’s debt-to-earnings before interest, taxes, depreciation, and amortization (debt/EBITDA) was more than 5.0. As a result, the company now finds itself having to sell off longstanding valued assets in order to maintain operations.
Catalina Marketing – This former leader in coupon marketing strategies is trying to overcome a dying business model in an evolving marketplace. But in the process, Catalina Marketing has taken on more than $1.6 billion in debt while seeing its revenues progressively decline. The company’s debt-to-earnings ratio is now higher than 12.0, which indicates a highly constrained financial environment. With such a high percentage of revenues going to pay off debt, opportunities for growth and revitalization are reduced. Since hiring turnaround specialist Gerald Sokol Jr. as President and CEO in October, it is rumored the company may be seeking chapter 11 bankruptcy protection, due to its debt and poor sales performance.
AT&T Inc. – This Texas-based conglomerate is the world’s largest telecommunications company and a giant in the mobile phone sector. But despite AT&T’s size and recent expansion – it acquired Time Warner – the company is saddled with roughly $190 billion in debt ($82 billion of which stems from the Time Warner deal). This debt load has put a damper on AT&T’s growth outlook, along with its stock price and will continue to do so for some time.
Diligence and Stewardship Is Important When Managing Business Debt
Not knowing what is too much debt for a business can undermine success in a short amount of time. For companies already in debt trouble, debt restructuring may be an option while employing better business practices.
For others, keeping an eye on debt and various other financial indicators is essential. This means routinely assessing short- and long-term debt, equity, revenues, and earnings to identify the current debt profile. And it requires knowing the company’s industry’s standards related to these business debt indicators.