By Meziane Lasfer 

The Wall Street Journal dated 4th March stated that 216 non-financial companies in the S&P 500 cut their debt-to-capitalisation ratio in the past year from 43% in 2012 to 35.4% in 2013. Even though this ratio, measured as debt over the sum of debt and shareholder equity (it wasn’t clear as to whether this is at market or book value), is higher than 35.4% in 2011, it indicates that firms are relying less on debt finance. On the face of it, the fact that so many companies cut their debt might be good news, as they reduced their financial risk. It suggests that they may have been in the past over levered with potential difficulties of servicing their debt, and the reduction in debt is likely to lead to safer firms and financial markets, and may result in an increase in growth.

However, we cannot be certain that this is the case, particularly if this decrease in debt is due to the following factors:

Firstly, a lack of investment opportunities. Companies may have decreased their debt because they do have any good investments. Worst, it could be that firms are in declining stage of their life cycle, and, therefore, they use their cash to pay back their debt. However, the overall trend in the US stock market appears to indicate the other way, i.e., that companies are at growth. Are companies giving different signals from the stock market? Is the money returned to debt holders going to find a way to the stock market and lead to a stock market bubble?

Secondly, debt holder monitoring: the decrease in leverage may indicate that firms are running away from debt-holder activism, and since shareholders do not have significant power to monitor managers, the reduction in debt will lead to an increase in the agency conflicts. Consequently, the future growth is hampered.

Thirdly, excess cash: are firms still growing but are they using cash to undertake their investments, because it has low transaction and monitoring costs? In this case, why don’t they use the cash to buyback more shares instead of reducing their debt? By reducing their debt, they are likely to increase their cost of capital, and therefore, reduce their growth.

Fourthly, taxation: are firms expecting a reduction in the corporate tax rates or in the proportion of interest that can be set against the tax, thus lowering the debt tax shields?

Finally, bankruptcy costs: Are firms expecting an increase in the bankruptcy risk, thus, lowing of their credit ratings and signaling bad times to come?

Overall, the information is ambiguous. In order to understand what is happening, and to assess fully whether this is good or bad for the economy, we need much deeper analysis of the reasons underlying this decrease in debt financing.

About the Author

Meziane is Professor of Finance at Cass Business School, City University London. His research interests include Corporate Finance, Governance and Capital Markets. He has published widely in top international academic journals such as Journal of Finance, Journal of Finance and Quantitative Analysis, Journal of Banking and Finance, Journal of Corporate Finance, Financial Management, European Financial Management, and National Tax Journal. His research was widely reported in the press and was sponsored by the National Association of Pension Funds (NAPF), the Finance Lease Association (FLA), Morley Asset Management, ICAEW, Donaldsons and Land Securities-Trillium. He is ranked among the top 20 top researchers in Europe*.  Full Profile