Debt: An Inescapable Concept Part 3: Business Debt

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Debt is an
inescapable concept. It is never a question of debt or no debt.
It is always a question of which kind of debt, owed to whom, when.

I have previously
covered the related issues of social debt and personal debt. Business
debt is different, because a business is not biological. A business
survives or perishes ("lives" or "dies") in
terms of decisions made by people outside the business: customers.

This can also
be said of individuals. We are all dependent on others. Then what
are the economic differences between a human being and a business?

First, a business
does not have a moral claim on the charity of others, unlike the
members of a family. It exists to serve customers. The customers’
hammer over a business is money: the most marketable commodity.
A business cannot survive if it does not earn a return on the investments
made by owners. So, customers determine the fate of every business.

Second, unlike
an individual, a business is not self-conscious. A business is not
an acting individual. It is a tool of acting individuals.

Third, it does
not produce in order to consume. It produces in order to make a
profit from its assets. These profits are either transferred to
business owners or reinvested to produce more profits.

Fourth and
decisively, a business has no soul. It faces no eternal sanctions.

FIVE
WAYS TO FINANCE A BUSINESS

A business
has five sources of capital: (1) invested time and/or money from
its founders; (2) money from passive investors who purchase part
ownership; (3) loans from individuals, banks, or other financial
organizations; (4) loans from its customers; (5) reinvested profits.
Capital comes from owners, lenders, and customers.

Entrepreneurs
have great confidence in their business vision. They prefer not
to share ownership.

A small group
of outside owners will often attempt to substitute their vision
for the entrepreneur’s vision. The organization can take on the
characteristics of a committee — a divided committee. Committees
are notoriously ineffective as entrepreneurial institutions. It
is too difficult to establish the blame for bad decisions. "Success
has a hundred fathers, but failure is an orphan."

In contrast,
lenders want only a guaranteed rate of return on their money. They
do not want to exercise control over the business. They have no
legal control over the business. This is ideal for an innovator.
As long as the business meets its payment schedule, lenders stay
out of management.

This is why
debt is the preferred path for founders. Until the business is up
and running and growing fast, founders do not want to bring in new
owners. Until the business is so successful that so many owners
will want to invest that their decision-making authority is diffused
and therefore de-fused, the founder does not want to sell shares
to the public.

Sometimes,
customers are asked to become lenders, although they do not perceive
their position as lenders. The best example of this arrangement
is a subscription. Subscribers provide money in advance to receive
published materials. The owner has an obligation to deliver the
subscription, but he surrenders no control to subscribers. They
can cancel their subscriptions or fail to renew, but they have no
legal authority to tell the publisher’s owner or editor what to
write about.

TRANSACTIONS

Prior to 1945,
most people bought with cash: coins or currency. They did not have
checking accounts. Most businesses were operated in terms of instant
transactions. At a retail market, you picked up items you wanted
to buy, went to the counter, and paid cash for them. The clerk deposited
the money in a cash register. There was very little time or trust
involved at the point of sale, other than the customer’s trust in
the product’s quality.

Checks take
time to clear the banks. In a week, the check clears, and the transaction
is over. During this time, the seller extends credit to the buyer.
He trusts the buyer.

Credit cards
appear to be close to instantaneous. This is deceptive. There are
multiple debt and trust relationships involved. The seller’s merchant
account (bank) extends credit to him for a transaction fee. If the
buyer is using a stolen card, the seller will not lose any money.
On the other side of the transaction, the buyer’s bank extends credit
to him, which its owners dearly hope he will not pay off soon —
not at 10% to 33% per annum.

Debit cards
are basically digital currency. There is no credit involved. The
money spent is immediately deducted from the buyer’s account.

At a Dollar
General store, you can purchase anything with a debit card. You
cannot purchase anything with a credit card. The seller saves money
by not paying for the credit side of the operation.

So, it is possible
to stay in business without debt by insisting on currency or a debit
card, but I know of few conventional businesses that operate solely
in terms of currency. The illegal drug trade operates with currency
only. So do gun shows. But these are not conventional operations.

In business,
debt is not quite inescapable, but it is close.

DEBT-TO-EQUITY
RATIO

The solvency
of businesses, especially publicly traded corporations, are rated
in part in terms of their debt to equity ratio.

The simplest
concept of equity is the net value of the business if sold for cash.
This is established by dividing its net income per year by the rate
of interest. A business generating a million dollars a year, net,
in an economy where the 10-year interest rate is 5% is worth $20
million.

Money in the
bank is considered equity. There are variations of this. Credit
in the form of 90-day loans extended to customers is considered
close to money in the bank. This money probably earns a higher rate
of return than money in a bank. There is a greater risk of default,
but when spread over many customers in boom times, this form of
credit was considered positive. It is equity.

Debt is legally
a liability. It is a legal claim on the stream of income generated
by the business. So, these payments reduce the stream of income.
They therefore reduce equity.

There was a
time when the debt-to-equity ratio was supposed to be low in order
to gain a high credit rating. It is not taken nearly so seriously
today.

Debt for the
expansion of production facilities is considered positive, though
not unlimited. Credit rating services look at the internal rate
of return on the plant and equipment, and then evaluate the effect
of rising debt. It is generally assumed that a growing business
with positive cash flow and rising equity could sustain an increase
in the debt-to-equity ratio. This is a way to finance expansion,
meaning market share. Rising market share allows greater price competition.
Wal-Mart is the great example of this process in our era.

The United
States in the late nineteenth century ran a balance of payments
deficit. Foreign investment flowed in to take advantage of perceived
opportunities. Railroads were a major growth area of the economy.
So was real estate. The debt was used to expand output, not finance
consumption. Consumer debt grew rapidly only in the 1920′s, when
the country was running balance of payments surpluses.

Today, debt
is used increasingly to finance mergers and acquisitions. Companies
buy their competitors. They also buy unrelated businesses as a way
to diversify. This is common in boom phases of the economy. When
recession hits, the companies sell off their component parts at
a loss and return to the core business.

Another major
use of debt is to finance stock repurchases from the public. This
reduces the supply of shares available for investors. This drives
up stock prices. Senior managers, because of American tax law, prefer
to be compensated by the use of stock options. Salaries over a million
dollars a year may not be deducted from pre-tax corporate expenses.

Management’s
performance is commonly measured by stock prices. So, by using corporation
money that could have gone for capital expansion, senior management
uses it to increase the share price: reduced supply, increasing
demand (from the corporation). The top managers are usually in senior
management for under ten years, so they must make hay while the
sun shines. This policy is hit hard when a recession hits. The company’s
share prices fall. Meanwhile, the firm does not own capital to increase
market share at the expense of competitors in a down market.

This strategy
is used to fend off corporate raiders, who buy up shares to gain
control over a firm. Successful raiders then fire existing managers.
The managers don’t want this, so they use corporate income to defend
their careers.

Corporate debt
has risen for a generation in the United States, but consumer debt
has risen faster. In the early 1970′s, the ratio of business debt
to total debt was in the range of one-third. Today, it is closer
to 20%.

Business debt
has a much greater chance of being productive than consumer debt.
It can be misused. Buying up company shares is surely a misuse of
corporate profits in the long run, although it is good for senior
managers and short-term holders of the shares. But business debt
for expansion still goes on. Consumer debt is present-oriented.
It is not spent to increase wealth except in the case of housing
debt, which can be used as a way to unload depreciating future dollars
onto creditors in exchange for an appreciating asset.

When a company
can borrow at 7% in order to earn 10%, debt is a good strategy,
depending on the phase of the business cycle. But debt is relentless.
It is a ticking meter. It must be serviced in good times and bad.

A company is
not a human being. It does not exist to consume. It exists only
to produce. Anything that turns it into a means of consumption for
its employees threatens its survival in a competitive market, unless
the form of consumption — subsidized cafeterias, gyms, and limousines
— is a means of retaining employees by offering tax-free compensation.

So, if it were
not for the business cycle, it would not matter whether the company
raises money by selling new stock, taking on more debt, or retaining
more earnings. It is when the downturn comes that it matters. Debt
is a legal liability irrespective of the company’s performance.
It drains the company’s income in the down phase. A company can
cease paying dividends. It cannot cease paying interest.

The policy
of the Federal Reserve has been to forestall the liquidation of
malinvested capital (recession) by pumping in new fiat money. This
has created a false sense of security among business managers. Increasing
corporate debt seems to be a better policy than increasing ownership
through the issue of new stock. This policy is good for senior managers,
who are compensated mainly by stock options. They want less stock
available to investors. But in the down phase of the cycle, the
policy of a higher debt-to-equity ratio places the company’s survival
in jeopardy.

WHEN
RECESSION HITS

Investors should
look for companies that are surviving the recession, but just barely,
due to their high debt-to-equity ratio. When it becomes clear that
the FED has begun its policy of reinflating, high-debt companies
are better candidates for purchase because of their leverage. Increasing
revenues have a more powerful effect in a high debt-to-equity company
than a low debt-to-equity company.

The opposite
is true in the early phase of a recession. You don’t want to own
shares of high debt-to-equity companies in any industry. That’s
when steady-Eddie companies are the wise fund manager’s choice.
Leverage will kill you in the down phase of the economy.

If the FED
would stay out of the capital markets, refusing to buy or sell T-bills
or other assets, then the American economy could begin to escape
home-brew recessions.

This does not
solve the problem of Asian central banks, whose purchases of T-bills
can affect interest rates in the United States. By creating a massive
inflation-driven boom in China, the Bank of China has created a
situation in which the boom-bust cycle spreads from China to its
trading partners. By making capital available to Western consumers,
China’s central bank has fanned the West’s consumer boom. Americans
take advantage of the bargains, while Chinese workers do without.
This is mercantilism, and it leads to misallocated capital. It is
now an international phenomenon.

CONCLUSION

Debt has legitimate
uses in business. It allows senior managers to finance their companies
without having to retain earnings or issue more shares of stock.
But when tax laws favor capital gains (lower rates) and also punish
companies that pay senior managers over a million dollars a year,
fiscal policy skews investment in favor of debt to fund stock repurchases.
The debt/equity ratio increases, leaving companies far more vulnerable
to recessions.

This
in turn calls forth the Federal Reserve, which once again stimulates
the economy through money creation and lowering short-term interest
rates. This leads to a steady-Eddie depreciation of the dollar.

Price
inflation harms creditors and benefits debtors. The taxing policies
and central bank policies of the United States favor the long-term
destruction of the dollar.

May
16, 2007

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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