We are all used to hearing that debt is bad and that debt should be paid off as soon as possible. Consumer debt definitely falls under this rhetoric because it’s debt that is taken on to purchase non assets typically, or in other words, things of zero value or depreciating value. Food, clothes, entertainment, car payments (depreciating value of car) are things that can be purchased with a credit card or line of credit.
As discussed in Lesson 54 and Lesson 55, not all debt is “bad”, and this includes purchases of assets that have value, like a house, especially if the asset value is large. How this relates to businesses and the healthiness of their balance sheet is very similar. Companies take on debt to purchase things in hopes of growing the business. Ideally, this growth exceeds the interest paid on the debt, or cost of capital. There are many historical examples of companies going “bankrupt” due to expenses exceeding revenue for a prolonged period of time. There are cases where bad management can lead to irresponsible spending and leverage to purchase assets, make acquisitions, or even on non capital goods (what about a $10,000 night out at the club?... that’s maybe an extreme example).
This possibility of bankruptcy is a real risk for any company, and this risk is one of many risks that is managed on a day to day basis by management and a board of directors. As a shareholder, this risk may seem scary because as a common shareholder, in the event of bankruptcy, you are one of the last in the queue line to be paid or “liquidated” behind preferred shareholders and creditors. Although the risk of bankruptcy is very small for most companies, it’s one of the many reasons why diversification is important in one’s investment portfolio.
But why do companies depend so much on debt? Why can’t every company be debt free? Afterall, this is healthier for shareholders and all of the company’s employees isn’t it? What would a completely debt free company look like? How would this translate to the overall publicly traded market? Let’s take a look and enjoy a walk through the hypothetical world of a debt free public market.
A company’s balance sheet consists of Assets, Liabilities, and Equity. Equity essentially measures what is the worth of the company. This is calculated by taking the amount of assets it owns and subtracting away any liabilities it owes. Without any debt, a company will essentially have close to zero liabilities (for simplicity, liabilities will be zero). Therefore, a company’s worth is simply equal to the value of the assets it owns. From Lesson 61, this is equivalent to a person’s net worth being equal to all of their cash, investments, and asset values with no consumer debt, no car payments, and no mortgage.
So, a company with no debt… what does this look like? Let’s start with the positives:
Debt Free Company- Positives
No debt means no debt payments, which means no interest payments. This is an improvement to the net income for the company
There is no need to engage with lenders or banks to sign a loan agreement. A company won’t have to worry about credit risk, or liquidity concerns in case it needed to suddenly pay back a debt balance. As long as net income consistently remains positive, these concerns are absent from management’s agenda.
Zero debt may actually keep companies in check with spending, share buybacks, and perhaps even share issuances since there would be no real reason to raise capital other than to buy more assets (I’ll tie back into this later). Spending being kept “in check” may actually create more responsible board and executive decisions around business operations, in turn meaning less frivolous spending, and easier accounting. Financial statements may actually be more transparent without the existence of debt, and perhaps it would be easier to measure management effectiveness within the company, and across the industry. This all sounds pretty good, right? So then why are there not a lot of debt free companies?
To answer this, we must understand why businesses take on debt in the first place. Well it’s simple… to grow their business and to grow net income. Companies borrow money to fund its continued operations, buy assets, pay its employees, or fund an acquisition, to name a few. Alternatively, a company may borrow money to pay dividends and buy back shares, or pay off other debt… although I would lump these under the “non ideal” drivers to borrow money. Let’s look at the negatives of a company with no debt:
Debt Free Company – Negatives
At the end of the day, companies take on debt to grow their business and net income. Without debt, companies will have a more difficult time growing their business. A business can only grow if they consistently make revenue that is growing. Without debt, growth will take longer, which means lowered projected future earnings and lowered profitability guidance going forward for the company. This could lead to lower valuations and in turn a depressed price of the stock. Present value of a business is lower because growth is lower, which in turn makes the business a less attractive investment compared to a higher growth scenario.
No tax shield advantages without any debt. This may be seen as a non optimized capital structure, especially with interest rates being so low right now
A company that has slow growth means there is a lower rate of new jobs created within the company. There is no compounding of returns on assets or investments by use of leverage (i.e. debt). In essence, the amount of compounding of investment returns over time is essentially capped to the growth rate of the overall economy.
No debt means the transfer of cash to and from customers is a lot higher since accounts payable and accounts receivable are minimal and will only reflect delayed cash payments in the short term. Else, all transactions are more or less “immediate” and in the form of cash or assets. As mentioned in Lesson 22, a faster movement of cash within an economy would usually mean an increase in economic growth and inflation. However, cash levels within a company will solely be dependent on Retained Earnings levels based on the accumulation of net income over time, and these will remain muted while growth of the business is low.
Mergers and acquisition (M&A) activity would be minimal and only be done by companies with large cash balances, or companies willing to issue shares to finance the deal, and to get to this point means that companies are parking this money on the side and not buying long term assets in the meantime.
In the end, to get around the slow growth problem, the only means to grow largely would be through capital intensive M&A, and that would only be after growing a sustainable cash balance over a long period of time in order to be able to carry out such M&A activity. In our hypothetical example here, a company’s net income growth trend may look something like this in Figure 1, where the spike in growth rate is during a year in which a company does a merger or acquisition, while growth remains muted in other years.
Figure 1: Sample Earnings Trend and Annual Growth Rate
How would the absence of debt affect new emerging companies in a particular sector? Well, for one, raising capital to kick start a business would be solely through issuing shares publicly and/or relinquishing ownership to venture capitalists and angel investors through seed funding rounds. In the early years of operation, losses will be more difficult to handle since it cannot be temporarily offset with debt capital, even during the first stages of company growth. However, as discussed above, revenue growth is expected to be lower without access to debt, resulting in a longer time frame to breakeven. Companies would need sufficient liquidity to stay afloat, either through cash, liquid assets, or share issuances. It’s likely that newly listed companies, or simply new companies, would go bankrupt more often, and go bankrupt quicker, making it an attractive target for an acquisition by a larger company (this is almost contradictory to our earlier conversation, and becomes a chicken and the egg problem because M&A activity will be harder due to low growth).
Growth is severely stifled for new companies without the access to debt capital, and new entrants will have an extremely difficult time trying to become profitable during the first years of operation, without having to issue more shares to raise capital. To provide value to shareholders in this realm, businesses must find customers fast, and/or get lucky. If a business can offer a product that targets a niche area of a market, customer buy in could be quick, and a cult like following of the stock could even ensue that boosts share prices (look no further than Tesla, Shopify, and Zoom). Either that, or management must find some way to raise its stock price. Would this pave the way to stock manipulation by insiders and management becoming more likely? It’s possible!
Finally, let’s finish off this (fun?) hypothetical exercise by taking a brief 30,000-foot view of how a collection of debt-less companies would affect the public markets they trade in, as well as how this would affect the financial system.
If we extend this to the overall market, lower company valuations mean a depressed stock market with a lower overall growth of markets. Future anticipated earnings growth is what drives valuations of companies and the overall market, and it’s what helps justify to investors why a company is worth the price it is trading at. Although stock markets aren’t representative of the economy, it can certainly play a leading indicator and show strong correlation to the growth of an overall economy.
Without leverage, one could hypothesize that there is less liquidity available for investors and other institutions to actually purchase shares of the company. Institutional investors, pension plans, and retail investors would all see muted average returns across the indices, and this may shift investors’ focus to more fixed income instruments like bonds. The more money going into the bond market, the higher bond prices go, and the lower bond yields go. This creates almost a prisoner’s dilemma situation. The delta between equity and bond market returns might shrink a little bit, but the starting point of the relative comparison will have decreased on both sides (for example, average market returns go from 7% to 5%, and bond yields go from 2% to 1%). Therefore, investors are worse off either way in this debt-less environment.
The absent need for debt means that a very limited role will exist now for banks and lenders that service publicly traded companies. Financial institutions would exist solely to broker M&A deals, and primarily to cater to retail level and individual consumers and clients. I don’t see this resulting in much growth for the financial system, let alone big banks. Financial services offered by lenders are now rendered useless, and a large segment of a bank’s revenue stream would become dissipated. If companies now operate only on the transfer of cash and assets, what role would banks really fulfill anymore? Simply put, the financial system would collapse and would certainly have to be restructured and consolidated to remain functional and valuable.
Alright we’re done!
While this hypothetical exercise was fun for me to brainstorm without boundaries, it does highlight the important role that debt plays for businesses, and individuals, to finance the purchase of large assets and to grow earnings over time. Companies who borrow money responsibly to purchase assets and to grow their business are effectively using leverage for optimal investment returns, which is reflected in a company’s stock price trend. Being able to capture a return on one’s investments that exceeds the cost of debt used to finance the investment is crucial to the growth of a business, and economy, over time. There are certainly successful companies out there that operate debt free, but it does pose the question whether changing the capital structure of these businesses to incorporate some level of leverage can amplify returns for its shareholders or not, and whether executive management has the capability to do so effectively, instead of blankly staring at available levers. It’s certainly worth being cognizant of when doing your research on which stock to invest in.