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.

May16, 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.

Copyright © 2007 LewRockwell.com