Every business cycle has a debt build up followed up an inevitable deleveraging. In order to grow their businesses in excess of existing cash flow, firms need to take out debt when the economy is expanding and they need to de-risk the balance sheet in times of financial stress to bring the debt to equity ratio to palpable levels, as well as to avoid cutting the dividend, having their debt downgraded, or in the worst case scenario bankruptcy. Firms obviously never plan to go bankrupt, but capital markets can seize up all at once, creating a liquidity crisis for indebted firms who would normally survive. Outside of liquidity crunches bankruptcies happen to poorly run businesses in weak industries.
It’s a fair question to wonder why firms take out so much debt during expansions. In a previous article titled Is There A Corporate Debt Bubble? we discussed the nuances of evaluating equity vs debt. Companies largely take out excess debt because management teams don’t know when a recession will occur. They get paid to operate the business and fund initiatives to grow the company. If a firm doesn’t take on new debt to grow the business, it can fall behind to competition. The management team can be fired for being too conservative instead of growing the company; meaning they don’t even make it to the end of the business cycle when their conservative stance would pay off. It’s easy to use hindsight to question why a firm would be aggressive before a recession, but at the time the demand supported those actions. We’re not excusing aggressive behavior with poor timing. Instead we’re explaining why it occurs.
Corporate Debt At A Record High For Median Firms
The discussion of why firms take out leverage is an important one now because of the heightened corporate leverage. As you can see, from the chart on the left, the aggregate net debt to EBITDA isn’t that high, but the median firm has record net leverage.