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This report examines the debt to equity ratio of firms in the US to evaluate the average debt to equity ratio of all firms and sectors in the US, and how it has changed in the last few years. Data from 4642 US-listed entities is utilized in this report. The report also presents the average leverage ratio of all firms and sectors in the US. The debt to asset ratio (leverage ratio) and its changes are also presented and discussed in this report.
These two ratios are primarily used to assess the solvency of the firm(s) in question. The ratio can be used to compare a company's level of leverage/debt against its competitors and its primary industry. A higher level of liabilities, compared to competitors or the industry, raises concerns regarding the company's ability to remain a going concern (stay operational). These ratios are widely used by the stakeholders to assess the health of the firm(s) in question and to evaluate future performance prospects.
(Source of data: Ready Ratios)
The data reveals that the average debt to equity ratio for all firms in the US, in 2020, stood at 1.39; it stood at 137% in 2019, 106% in 2018, 0.98 in 2017, 108% in 2016, and 97% in 2015. (Clarification: debt level of $1 for every $2 in equity would equate to 50% D/E ratio, and $1 for $1 in a D/E ratio of 100%)
The average debt to equity ratio and thus the solvency position of an average US firm deteriorated by 41.24% in the last five years, 2020- 2015, indicating that firms have significantly increased debt in the last five years.
This also means that firms' leverage, as calculated by debt to asset ratio of firms, stood at 49% in 2015, rising to 59% in 2020.
Impact of Rising business debt levels on the US equity market
These insights are also important for the analysis of the broader US equity market. As debt increases, after a specific level, it impacts the risk associated with equity (Modigliani and Miller with tax theorem). As gearing increases, the weighted average cost of capital for firms (WACC) decreases steadily; initially as interest is tax-deductible (at tax rate), but equity returns are not.
Due to lower tax outflow and, generally, lower cost of debt finance compared to equity, as debt increases, initially, the WACC goes down, and as it is the effective discount rate for the company, the company's market value should increase. Thus, in the presence of taxes, the downward force on the WACC by the impact of debt finance, overpowers the upward force of the increases in the cost of equity.
However, in practical terms, after a certain leverage level, for example, beyond the tax exhaustion point, at very high levels of leverage when the taxable profit, isn't just zero, but is negative, due to very high-interest outlay, there will be no profits to deduct interest from after a certain leverage level is reached, this condition would oxidize the benefits of debt finance and the debt tax shield.
Furthermore, at high levels of debt, the covenants (constraints) imposed by lenders restrict firms strategically and also require firms to meet certain requirements that may prevent management from implementing the most optimal strategies or tactics, to maintain covenants. Additionally, at high leverage levels, the probability of bankruptcy also increases, and this risk is examined by stakeholders, and factored in their valuation models.
Optimal leverage level may be different for different industries based on the stability, structure, and financial dynamics of the industries; however, after a certain leverage level, generally considered above 65% (approximately a debt to equity ratio of 1.7), due to the abovementioned causes, the risk associated with the equity rises precipitously.
The returns that equity holders demand should increase. This expectation of increased returns by equity holders should be proportionate to the decrease in the WACC caused by the lower cost of capital for debt finance, offsetting the reduction by an increase in the cost of equity.
Equity market risks caused by increased leverage and borrowing by firms
The fundamentals of the economy are weak, which could mean that lower interest rates persist long-term. Lower interest rates are a significant, some would say only, contributor to the substantial increase in borrowing by firms in the last few years.
If lower interest rates persist and the borrowing by firms continues to increase, we may see a substantial increase in the risk premium demanded by the market; this simply translates to a higher rate of return demanded by the market. If this condition persists, with increased debt and covenants imposed by debt, companies wouldn't be able to increase dividends to satisfy the need for increased returns. That would, of course, lead to downward pressure on equity prices.
This risk is especially important to monitor for firms in industries that have historically had a ‘reasonable’ level of leverage. These could be industries severely impacted by the adverse impacts of lockdowns, etcetera. Other industries may be negatively impacted by industry-specific issues and long-term trends; for example, the D/E ratio of the coal industry has increased by a very concerning 42.4 times.
Continually monitoring this risk can aid both businesses and investors in their financial strategies.