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Explain how EBIT influences debt capacity and the relevance of…
Explain how EBIT influences debt capacity and the relevance of Donaldson’s classic article (attached below) in 2023.
New Framework for Corporate Debt Policy
By Gordon Donaldson
FROM THE SEPTEMBER 1978 ISSUE, HARVARD BUSINESS REVIEW
Few, if any, articles on finance that have appeared in HBR have enjoyed the influence of the 1962 article reprinted here as a “Classic.” Gordon Donaldson’s analysis of how many companies haphazardly established their debt capacity, and his careful explanation of what he considered a better way, seemed to strike a chord among corporate administrative and financial officers. But the article was more than a timely essay; it remains a valuable guide, a stimulus to rational thought about building a debt policy from the ground up. Indeed, 16 years later “New Framework for Corporate Debt Policy” still sells steadily in reprints. Judging from the retrospective commentary prepared by the author for this republication, he would not change much if he were writing the article today.
Retrospective Commentary
Why are many common rules of thumb for evaluating a company’s debt capacity misleading and even dangerous?
Why is outside experience and advice of limited value as a guide to top management’s thinking about debt capacity?
What approach will enable management to make an independent and realistic appraisal of risk on the basis of data with which it is already familiar and in terms of judgments to which it has long been accustomed?
The problem of deciding whether it is wise and proper for a business corporation to finance long-term capital needs through debt, and, if so, how far it is safe to go, is one which most boards of directors have wrestled with at one time or another. For many companies the debt-capacity decision is of critical importance because of its potential impact on margins of profitability and on solvency. For all companies, however large and financially sound they may be, the decision is one to be approached with great care. Yet, in spite of its importance, the subject of corporate debt policy has received surprisingly little attention in the literature of business management in recent years. One might infer from this either that business has already developed a reliable means of resolving the question or that progress toward a more adequate solution has been slow.
In my opinion, the latter inference is closer to the truth. The debt-equity choice is still a relatively crude art as practiced by a great many corporate borrowers. It follows that there is a real opportunity for useful refinement in the decision-making process. However, there is little evidence, at present, of serious dissatisfaction with conventional decision rules on the part of those responsible for making this decision. Over the past three years I have been engaged in sampling executive opinions on debt policy, and I have found little indication of the same kind of ferment as is going on with regard to capital budgeting decisions.
The primary purpose of this article, therefore, is to stimulate dissatisfaction with present-day conventions regarding debt capacity and to suggest the direction in which the opportunity for improvement lies. I intend to show that the widely used rules of thumb which evaluate debt capacity in terms of some percentage of balance sheet values or in terms of income statement ratios can be seriously misleading and even dangerous to corporate solvency. I also intend to develop the argument that debt policy in general and debt capacity in particular cannot be prescribed for the individual company by outsiders or by generalized standards; rather, they can and should be determined by management in terms of individual corporate circumstances and objectives and on the basis of the observed behavior of patterns of cash flows.
The question of corporate debt capacity may be looked at from several points of viewe.g., the management of the business concerned, its shareholders or potential shareholders, and, of course, the lender of the debt capital. Because each of these groups may, quite properly, have a different concept of the wise and proper limit on debt, let me clarify the point of view taken in this article. I intend to discuss the subject from the standpoint of the management of the borrowing corporation, assuming that the board of directors which will make the final decision has the customary mandate from the stockholders to act on all matters concerning the safety and profitability of their investment.
For the reader who ordinarily looks at this problem as a lender, potential stockholder, or investment adviser, the analysis described in this article may appear at first sight to have limited application. It is hoped, however, that the underlying concepts will be recognized as valid regardless of how one looks at the problem, and they may suggest directions for improvement in the external as well as the internal analysis of the risk of debt.
Nature of the Risks
In order to set a background for discussing possible improvements, I will first describe briefly certain aspects of conventional practice concerning present-day decision rules on long-term debt. These observations were recorded as a part of a research study which sampled practice and opinion in a group of relatively large and mature manufacturing corporations. The nature of this sample must be kept in mind when interpreting the practices described.
Hazards of Too Much Debt
The nature of the incentive to borrow as an alternative to financing through a new issue of stock is common knowledge. Debt capital in the amounts normally approved by established financial institutions is a comparatively cheap source of funds. Whether it is considered the cheapest source depends on whether retained earnings are regarded as “cost free” or not. In any case, for most companies it is easy to demonstrate that, assuming normal profitability, the combination of moderate interest rates and high levels of corporate income tax enable debt capital to produce significantly better earnings per share than would a comparable amount of capital provided by an issue of either common or preferred stock. In fact, the advantage is so obvious that few companies bother to make the calculation when considering these alternatives.
Under these circumstances it is apparent that there must be a powerful deterrent which keeps businesses from using this source to the limits of availability. The primary deterrent is, of course, the risks which are inevitably associated with long-term debt servicing. While it is something of an oversimplification to say that the debt decision is a balancing of higher prospective income to the shareholders against greater chance of loss, it is certainly true that this is the heart of the problem.
When the word “risk” is applied to debt, it may refer to a variety of potential penalties; the precise meaning is not always clear when this subject is discussed. To most people, however, riskso far as debt is concernedis the chance of running out of cash. This risk is inevitably increased by a legal contract requiring the business to pay fixed sums of cash at predetermined dates in the future regardless of the financial condition at that time. There are, of course, a great many needs for cashdividends, capital expenditures, research projects, and so onwith respect to which cash balances may prove inadequate at some future point.
Too Little Cash
The ultimate hazard of running out of cash, however, and the one which lurks in the background of every debt decision, is the situation where cash is so reduced that legal contracts are defaulted, bankruptcy occurs, and normal operations cease. Since no private enterprise has a guaranteed cash inflow, there must always be somerisk, however remote, that this event could occur. Consequently, any addition to mandatory cash outflows resulting from new debt or any other act or event must increase that risk. I have chosen to use the term “cash inadequacy” to refer to a whole family of problems involving the inability to make cash payments for any purpose important to the long-term financial health of the business; “cash-insolvency” is the extreme case of cash inadequacy. It should be emphasized that although debt necessarily increases the chances of cash inadequacy, this risk exists whether the company has any debt or not, so that the debt-equity choice is not between some risk and no risk, but between more and less.
Conventional Approaches
Observation of present-day business practice suggests that businessmen commonly draw their concepts of debt capacity from one or more of several sources. Thus, they sometimes
1. Seek the counsel of institutional lenders or financial intermediaries (such as investment bankers): Most corporate borrowers negotiate long-term debt contracts at infrequent intervals, while the lender and the investment banker are constantly involved in loan decisions and so, presumably, have a great deal more experience and better judgment. Further, it is apparent that unless the lender is satisfied on the question of risk, there will be no loan. Finally, banks and insurance companies have a well-established reputation for being conservative, and conservative borrowers will take comfort from the fact that if the lender errs, it will likely be on the safe side.
2. See what comparable companies are doing in this area of financial management: Every business has an idea of those other companies in or out of the industry which are most like themselves so far as factors affecting risk are concerned. Since this is an aspect of corporate policy which is public information, it is natural that the debt-equity ratios of competitors will be carefully considered, and, lacking more objective guides, there will be a tendency to follow the mode and reject the extremes. This approach has an added practical appeal; group norms are important in the capital market’s appraisal of a company’s financial strength. If a company is out of line, it may be penalizedeven though the deviation from the average may be perfectly appropriate for this company.
3. Follow the practices of the past: There is a very natural tendency to respect the corporation’s financial traditions, and this is often apparent with regard to debt policy. Many businesses take considerable pride in “a clean balance sheet,” an Aa rating, or a history of borrowing at the prime rate. It would border on sacrilege to propose a departure which would jeopardize these cherished symbols of financial achievement and respectability! The fact that these standards have apparently preserved corporate solvency in the past is a powerful argument for continuing them, particularly if the implications of a change cannot be precisely defined.
4. Refer to that very elusive authority called “general practice,” “industry practice,” “common knowledge,” or, less respectfully, “financial folklore”: Remarkable as it seems in view of the great diversity among companies classified as industrials, there is widespread acceptance of the belief that an appropriate limit to the long-term borrowing of industrial companies is 30% of capitalization (or, alternatively, one-third). The origin of, or rationale for, this particular decision rule has been obscured by the passage of time, but there is no doubt that it has become a widely honored rule of thumb in the decisions of both borrowers and lenders.
Fallacy of Double Standard
Without denying the practical significance of some of the considerations which have led businessmen to follow these guides in formulating debt policy, it must be recognized that there are serious limitations inherent in using them (separately or as a group) as theonly guides to appropriate debt capacity.
First, consider the practice of accepting advice from the lender. As the lender views the individual loan contract, it is one of a large number of investments which make up a constantly changing portfolio. When negotiated it is only one of a stream of loan proposals which must be acted on promptly and appraised in terms of the limited information to which generalized standards are applied. The nature of the risk to the lender is necessarily influenced by the fact that this loan is only a small fraction of the total sum invested and that intelligent diversification goes a long way to softening the impact of individual default. Further, even when default occurs, all may not be lost; in time the loan may be “worked out” through reorganization or liquidation.
All this is small comfort to the borrower. The individual loan which goes sourif it happens to be his loanis a catastrophe. There are few businessmen who can take a lighthearted attitude toward the prospect of default on a legal contract with the associated threat of bankruptcy. To most, this is viewed as the end of the road. Also, it is important to recognize that while the lender need only be concerned about servicing his own (high priority) claims, the borrower must also consider the needs which go unsatisfied during the period prior to the time of actual default when debt servicing drains off precious cash reserves.
This is not to imply that the lender is insensitive to individual losses and their effect on the business concerned; but it does mean that risk to the lender is not the same thing as risk to the borrower, and, consequently, the standards of one are not necessarily appropriate for the other. The lender’s standards can at times be too liberalas well as too conservativefrom the borrower’s point of view.
Some will argue that, as a practical matter, the borrower must accept the debt-capacity standards of the lender, else there will be no contract. However, this implies that there is no bargaining over the upper limit of the amount that will be supplied, no differences among lenders, and/or no shopping around by borrowers. While all institutional lenders do have absolute limits on the risks they will take (even at a premium interest rate), there is often some room for negotiation if the borrower is so disposed. Under some circumstances there may be valid reasons for probing the upper limits of the lender’s willingness to lend.
Lessons of Experience
The second source of guidance mentioned is the observed practices of comparable businesses. This, too, has its obvious limitations. Even assuming strict comparabilitywhich is hard to establishthere is no proof that the companies concerned have arrived at their current debt proportions in a deliberate and rational manner. In view of the wide variations in debt policy within any industry group, there can be little real meaning in an industry average. And what happens if every member of the group looks to the other for guidance? The most that can be said for this approach to debt policy is that the company concerned can avoid the appearance of being atypical in the investment market so far as its capital structure is concerned. But, as in most areas of business, there is a range of acceptable behavior, and the skill of management comes in identifying and taking advantage of the limits to which it can go without raising too many eyebrows.
Even a company’s own direct experience with debt financing has its limitations as a guide to debt capacity. At best, the evidence that a particular debt policy has not been a cause of financial embarrassment in the past may only prove that the policy was on the conservative side. However, if assurance of adequate conservatism is the primary goal, the only really satisfactory policy is a no-debt policy.
For companies with some debt the experience of past periods of business recession is only partial evidence of the protection a particular policy affords. In most industries, the period of the past 20 years has produced a maximum of four or five periods of decline in sales and earnings. This limited recession experience with the behavior of cash flowsthe critical consideration where debt servicing is involvedcan be misleading since cash flows are affected by a variety of factors and the actual experience in any single recession is a somewhat unique combination of events which may not recur in the future. Thus, the so-called test of experience cannot be taken at face value.
Inescapable Responsibility
In summing up a criticism of the sources from which management commonly derives its debt capacity standard, there are two aspects which must be emphasized. Both of these relate to the practice of relying on the judgment of others in a situation where management alone is best able to appraise the full implications of the problem. The points I have in mind are as follows:
1. In assessing the risks of running out of cash because of excessive fixed cash obligations, the special circumstances of the individual firm are the primary data that the analyst has to work with. Management has obvious advantages over outsiders in using this data because it has free and full access to it, the time and incentive to examine it thoroughly, and a personal stake in making sensible judgments about what it observes. Even the judgments of predecessors in office are judgments made on information which is inadequate when compared to what management now has in its possessionif only because the predecessor’s information is now 10 to 20 years old. (Subsequently, we will consider how management may approach an independent appraisal of risk for the individual business.)
2. The measurement of risk is only one dimension of the debt-capacity decision. In a free enterprise society, the assumption of risk is a voluntary activity, and no one can properly define the level of risk which another should be willing to bear. The decision to limit debt to 10%, 30%, or any other percentage of the capital structure reflects (or should reflect) both the magnitude of the risk involved in servicing that amount of debt and the willingness of those who bear this riskthe owners or their duly authorized representativesto accept the hazards involved.
In the last analysis, this is a subjective decision which management alone can make. Indeed, it may be said that a corporation has defined its debt policy long before a particular financing decision comes to a vote; it has done this in its choice of the men who are to make the decision. The ensuing decisions involving financial risk will reflect their basic attitudeswhether they see a situation as an opportunity to be exploited or a threat to be minimized.
A most interesting and fundamental question comes up hereone that underlies the whole relationship between management and the shareholder; namely, does management determine the attitude toward risk bearing which the stockholders must then adopt, or vice versa? This is part of the broader question of whether management should choose those financial policies which it prefers and attract a like-minded stockholder group (taking the “if they don’t like it, they can sell out” approach) or by some means or other determine the attitudes and objectives of its present stockholder group and attempt to translate these into the appropriate action.
I do not propose to pass judgment on this difficult problem in the context of this article. The fact is, by taking one approach or the otheror some blendmanagement does make these decisions. With respect to risk bearing, however, one point is clear: responsible management should not be dealing with the problem in terms of purely personal risk preferences. I suspect that many top executives have not given this aspect the attention it deserves.
Reasons for Current Practice
Having considered the case for a debt policy which is internally rather than externally generated, we may well ask why so many companies, in deciding how far to go in using OPM (other people’s money), lean so heavily on OPA (other people’s advice). The answer appears to be threefold:
1. A misunderstanding of the nature of the problem and, in particular, a failure to separate the subjective from the objective elements.
2. The inherent complexity of the objective sidethe measurement of risk.
3. The serious inadequacy of conventional debt-capacity decision rules as a framework for independent appraisal.
It is obvious that if a business does not have a useful way of assessing the general magnitude of the risks of too much debt in terms of its individual company and industry circumstances, then it will do one of two things. Either it will fall back on generalized (external) concepts of risk for “comparable” companies, or it will make the decision on purely subjective groundson how the management “feels” about debt.
Thus, in practice, an internally generated debt-capacity decision is often based almost entirely on the management’s general attitude toward this kind of problem without regard for how much risk is actually involved and what the potential rewards and penalties from risk bearing happen to be in the specific situation. The most obvious examples are to be found in companies at the extremes of debt policy that follow such rules as “no debt under any circumstances” or “borrow the maximum available.” (We must be careful, however, not to assume that if a company has one or another of these policies, it is acting irrationally or emotionally.)
One of the subjects about which we know very little at present is how individual and group attitudes toward risk bearing are formed in practice. It is apparent, however, that there are important differences in this respect among members of any given management team and even for an individual executive with regard to different dimensions of risk within the business. The risk of excessive debt often appears to have a special significance; a man who is a “plunger” on sales policy or research might also be an arch-conservative with regard to debt. The risk of default on debt is more directly associated with financial ruin, regardless of the fundamental cause of failure, simply because it is generally the last act in a chain of events which follows from a deteriorating cash position.
There are other bits of evidence which are possible explanations for a Jekyll-and-Hyde behavior on risk bearing in business.
Debt policy is always decided at the very top of the executive structure whereas other policies on sales or production involving other dimensions of risk are shaped to some degree at all executive levels. The seniority of the typical board of directors doubtless has some bearing on the comparative conservatism of financial policy, including debt policy.
There is also some truth in the generalization that financial officers tend to be more conservative than other executives at the same level in other phases of the business, and to the extent that they influence debt policy they may tend to prefer to minimize risk per se, regardless of the potential rewards from risk bearing.
What Is a Sensible Approach?
The foregoing is, however, only speculation in an area where real research is necessary. The point of importance here is that, whatever the reason may be, it is illogical to base an internal decision on debt policy on attitudes toward risk alone, just as it is illogical to believe that corporate debt policy can be properly formulated without taking these individual attitudes into account.
For the purposes of a sensible approach to corporate debt policy we need not expect management to have a logical explanation for its feelings toward debt, even though this might be theoretically desirable. It is sufficient that managers know how they feel and are able to react to specific risk alternatives. The problem has been that in many cases they have not known in any objective sense what it was that they were reacting to; they have not had a meaningful measure of the specific risk of running out of cash (with or without any given amount of long-term debt).
It is therefore in the formulation of an approach to the measurement of risk in the individual corporation that the hope for an independent appraisal of debt capacity lies.
Inadequacy of Current Rules
Unfortunately, the conventional form for expressing debt-capacity rules is of little or no help in providing the kind of formulation I am urging. Debt capacity is most commonly expressed in terms of the balance sheet relationship between long-term debt and the total of all long-term sources, viz., as some percent of capitalization. A variation of this ratio is often found in debt contracts which limit new long-term borrowing to some percentage of net tangible assets.
The alternative form in which to express the limits of long-term borrowing is in terms of income statement data. This is the earnings coverage ratiothe ratio of net income available for debt servicing to the total amount of annual interest plus sinking fund charges. Under such a rule, no new long-term debt would be contemplated unless the net income available for debt servicing is equal to or in excess of some multiple of the debt servicing chargessay, three to oneso that the company can survive a period of decline in sales and earnings and still have enough earnings to cover the fixed charges of debt. As we will see shortly, this ratio is more meaningful for internal formation of policy but also has its limitations.
Now, let us go on to examine each type of expression more closely.
Capitalization Standard
Consider a company which wishes to formulate its own debt standard as a percent of capitalization. It is apparent that in order to do so the standard must be expressed in terms of data which can be related to the magnitude of the risk in such a way that changes in the ratio can be translated into changes in the risk of cash inadequacy, and vice versa. But how many executives concerned with this problem today have any real idea of how much the risk of cash inadequacy is increased when the long-term debt of their company is increased from 10% to 20% or from 20% to 30% of capitalization? Not very many, if my sample of management information in this area has any validity. This is not surprising, however, since the balance sheet data on which the standard is based provide little direct evidence on the question of cash adequacy and may, in fact, be highly unreliable and misleading.
While we do not need to go into a full discussion here of the inadequacies of relating the principal amount of long-term debt to historical asset values as a way of looking at the chances of running out of cash, we should keep in mind the more obvious weaknesses:
1. There is a wide variation in the relation between the principal of the debt and the annual obligation for cash payments under the debt contract. In industrial companies the principal of the debt may be repaid serially over the life of the debt contract, which may vary from 10 years or less to 30 years or more. Thus the annual cash outflow associated with $10 million on the balance sheet may, for example, vary from $500,000 (interest only at 5%) to $833,000 (interest plus principal repayable over 30 years) to $1.5 million (interest plus principal repayable over 10 years).
2. As loans are repaid by partial annual payments, as is customary under industrial term loans, the principal amount declines and the percent of capitalization ratio improves, but the annual cash drain for repayment remains the same until maturity is reached.
3. There may be substantial changes in asset values, particularly in connection with inventory valuation and depreciation policies, and as a consequence, changes in the percent of capitalization ratio which have no bearing on the capacity to meet fixed cash drains.
4. Certain off-the-balance-sheet factors have an important bearing on cash flows which the conventional ratio takes no cognizance of. One factor of this sort which has been receiving publicity in recent years is the payments under leasing arrangements.
(While various authorities have been urging that lease payments be given formal recognition as a liability on balance sheets and in debt-capacity calculations, there is no general agreement as to how this should be done. For one thing, there is no obvious answer as to what the capitalization rate should be in order to translate lease payments into balance sheet values. In my opinion this debate is bound to be an artificial and frustrating experienceand unnecessary for the internal analystsince, as will be discussed later, it is much more meaningful to deal with leases, as with debt, in terms of the dollars of annual cash outflow rather than in terms of principal amounts. Thus a footnoting of the annual payments under the lease is entirely adequate.)
Earnings-Coverage Standard
The earnings-coverage standard affords, on the surface at least, a better prospect of measuring risk in the individual company in terms of the factors which bear directly on cash adequacy. By relating the total annual cash outflow under all long-term debt contracts to the net earnings available for servicing the debt, it is intended to assure that earnings will be adequate to meet charges at all times. This approach implies that the greater the prospective fluctuation in earnings, the higher is the required ratio (or the larger the “cushion” between normal earnings and debt-servicing charges).
This standard also has limitations as a basis for internal determination of debt capacity:
1. The net earnings figure found in the income statement and derived under normal accounting procedures is not the same thing as net cash inflowan assumption which is implicit in the earnings-coverage standard. Even when adjustments are made for the non-cash items on the income statement (depreciation charges), as is commonly done in the more sophisticated applications, this equivalence cannot safely be assumed. The time when it may be roughly true is the time when we are least concerned about the hazards of debt, i.e., when sales are approximately the same from period to period. It is in times of rapid change (including recessions) that we are most concerned about debt burden, and then there arelikely to be sharp differences between net income and net cash flow.
2. The question of what the proper ratio is between earnings and debt servicing is problematical. In a given case should the ratio be two to one or twenty to one? If we exclude externally derived standards or rules of thumb and insist that a company generate its own ratio in terms of its own circumstances, how does it go about doing it? Perhaps the best that could be done would be to work backward from the data of past recessions, which would indicate the low points of net earnings, toward a ratio between this experience and some measure of “normal” earnings with the intention of assuring a one-to-one relationship between net earnings and debt servicing at all times. However, if this is the way it is to be done, the estimate of minimum net earnings would itself provide the measure of debt capacity, and it would be unnecessary to translate it into a ratio. Further, as already noted, there are hazards in a literal translation of past history as a guide for the future. And what of the case where the company has experienced net losses in the past? Does this mean that it has no long-term debt capacity? If a net loss is possible, no ratio between normal net earnings and debt servicing, however large, will assure the desired equality in future recessions.
The earnings-coverage standard does not appear to be widely used by industrial corporate borrowers as a basis for formulating debt policy. Where it is used, it appears either to derive from the advice of institutional lenders or investment bankers or merely to reflect the borrower’s attitude toward risk bearing. Its use does not seem to indicate an attempt to measure individual risk by some objective means.
A More Useful Approach
Granted the apparent inadequacies of conventional debt-capacity decision rules for purposes of internal debt policy, is there a practical alternative? I believe there is, but it must be recognized immediately that it rests on data which are substantially more complex than what the conventional rules require, and involve a considerably larger expenditure of time and effort to obtain and interpret. However, in view of the unquestioned importance of the debt-equity decision to the future of individual businesses, and in view of the fact that, as will be shown later, the data have a usefulness which goes well beyond the debt-capacity decision, there is reason to give this alternative serious considerati
