As profits soar, American business takes on more corporate debt. One would assume that the unprecedented corporate prosperity of the last decade would result in businesses paying down their debts. Not so. Corporate debt now equals 46% of gross domestic product, up from 38% five years ago.
Ironically, companies tend to pay down debt at the start of an economic boom and increase debt as the cycle nears its end. Presumably this tendency to reduce debt early in a boom cycle results from the excitement created by lessened financial pressure. Corporate debt fell in 1991, after the last recession.
Then, as the boom cycle continues, a kind of financial euphoria replaces the conservatism borne of hard times and companies bravely expand by taking more debt.
This pattern is not unprecedented. The longest periods of expansion before the current one were during the 1960s and 1980s. In each case, corporate debt rose rapidly in the final years of the expansion.
Now, evidence is growing that the economy is slowing and credit analysts are worrying that declining corporate profits may not be adequate in the future to service the nation’s corporate debt. Credit markets are tightening. The junk bond market is reluctant to finance many companies, and banks are growing more cautious.
One new twist in the current scenario is the debt load of companies who didn’t have to borrow. Many companies opted to borrow rather than sell more shares of stock in an attempt to leverage their stock price.
As the economy slows, the market may not be as receptive to stock offerings as in the past.
Refinancing the debt may become increasingly difficult. For these companies, sticking with conservative financing strategies would have avoided default.
The cycles of a free market economy are fairly predictable. Expansions, contractions, inventory build-up, inflation and interest rate fluctuations have existed throughout our history. The length of the cycles varies, but the cycles themselves do not.
The freedom and exuberance of the free market during good times inevitably leads to problems when the economy slows down. A mix of maximizing profits through expansion while keeping reserves adequate to weather the storm is the secret to success.
THOUGHT FOR THE MOMENT
Joy has nothing to do with material things, or with a man’s outward circumstances. A man living in the lap of luxury can be wretched, and a man in the depths of poverty can overflow with joy.
— clergyman and writer
William Barclay (1907-1978)
Joe D. Jones, CPA, is publisher of the Mississippi Business Journal. His e-mail address is firstname.lastname@example.org.