All that Cash!

October 15, 2010

Financial news outlets routinely speak about how much cash corporations have accumulated during the past year or two and that they are sitting on it rather than investing it in expansion plans.
 
At some point, the logic goes, the floodgates of spending will open and economic benefits will flow. The article below argues that while it’s true companies have a lot of cash, the origin of that cash is not earnings, but debt. From that view it really isn’t cash at all.
 
Interest rates are at record lows. So, corporations are issuing a lot of debt. That shows up on their balance sheets as cash. But that doesn’t mean the company has cash to spend.
 
As evidence of this the article depicts this chart which it says indicates that corporate leverage is at an all time high.
More debt than ever: Leverage for nonfinancial U.S. corporations.
 
If I had ever taken a class in Finance I would have learned that the most expensive type of financing is equity and the least expensive is debt. It works out that way because of the two, equity is harder to get. Equity holders take a lot more risk than bondholders (unless you happen to be a labor union holding equity, but that’s another story).
 
One way to boost earnings is to take on additional debt. If I buy a house for $100k with all cash and the house appreciates to $200k, then I’ve made 100%. If I buy a house with $20k with an $80k mortgage and the house appreciates to $200k, then I’ve made 500% less the interest expense.
 
It works the same way for corporations. In this environment it’s pretty easy to do that because interest rates are so low. Earnings per share go up. The CEO looks like a genius and gets a big bonus, and everyone is happy.
 
Except, the problem is the 50% leverage. If things get bad or interest rates go up, then what looks like a great strategy now could turn out to be a disaster. More for us, than the CEO.
 
http://www.marketwatch.com/story/the-biggest-lie-about-us-companies-2010-08-03
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