Corporate leverage: equity cushions are less comfy than they appear

Despite a recent explosion in debt issuance, Corporate America may be historically underleveraged. Analysts at Bank of America noted last month that the loans and bonds US companies carry relative to market capitalisation hit a record low in the second quarter: just 23 per cent. The ratio has been drifting down for some time. One implication is that companies have incremental capacity to issue more debt.

The analysts also noted that the metric has sometimes foreshadowed stock market swoons. The ratio hit lows in 2000, just before the dotcom crash, and again in 2007 ahead of the financial crisis.

Still, equity valuation should not be a first-order method for understanding leverage, even if pricey equities can be added to the long, debatable list of stock market altitude warnings.

Earlier this year, US leveraged finance — outstanding leveraged loans and junk bonds — exceeded $3tn for the first time. But absolute debt can mislead when the profits and cash flow used to service it are excluded. For the same reason, a nation’s debts are always be measured against gross domestic product.

According to the US Bureau of Economic Analysis, corporate net cash flow between 2017 and 2019 jumped by a quarter to $2.5tn. At the same time, as interest rates have plunged, the servicing costs of debt have fallen sharply.

Equity “cushion” or the amount of residual corporate value, measured by stock market valuation, sitting beneath debt and other liabilities is an intriguing measure but can be misleading.

Companies with high equity market capitalisations theoretically can absorb large losses before debt is impaired. But equity value is not cash itself and can quickly evaporate before a company can respond.

Canny businesses such as Tesla and cinema chain AMC Entertainment have in recent years recognised the disconnect between their weak cash flows and high market valuations. They have exploited plump equity cushions to raise cash by selling stock.

These financings provide a better pointer to overvaluation of specific shares than the ratio of debt to equity does for the market as a whole.

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