Corporate Deleveraging May Be Overstated

BreakingViews (free subscription required) reports that the degree of deleveraging of corporate balance sheets may be exaggerated. Yet another reason to look at stocks with a wary eye.

Readers may know that the level of corporate borrowings relative to their equity and total assets has fallen since 2002. For example, Standard & Poors reports that debt to equity ratio for the non-financial firms in the S&P 500 dropped from 75% to 40%. Balance sheet strength is one of many measures used to evaluate stocks.

But the picture may be less rosy than these figures suggest. A UK based analyst, Andrew Smithers, started to examine government statistics on corporate gearing. He noticed that the authorities had had to adjust their own figures to conform with the private sector reports, and dug into their reconciliation methods. He wasn’t comfortable with what he found. He then had a look at US accounting and also found it wanting.

Smithers made some adjustments and determined that UK debt ratios actually got worse, not better, and the US improvement appeared considerably overstated.

As BreakingViews tells us:

Smithers noticed that the trend {of falling corporate debt ratios] was different in the UK….When the assets are valued at replacement cost, the debt-asset ratio has actually increased, from 45% to 52%.

The US statistics measured replacement costs, but with a large “statistical discrepancy” that seemed to be used to reconcile top-down calculations with individual corporate accounts. Take away that adjustment, and the decrease in US corporate debt burdens was cut by more than half – from 70% to 55% of equity.

As a check, Smithers compared the ratio of corporate debt to domestic output. That has also declined, but only from 100% to 90%. That’s the same level as at the last peak, in 1990. In the 1970s, the ratio was mostly in the 60-70% range. Similarly, the ratio of financial debt to GDP has increased from 96% to 107% since 2002. Some of that additional financial debt may actually be non-financial corporate debt in disguise.

What’s going on, precisely? It seems that higher asset prices have made their way onto company balance sheets. There are many possible mechanisms, including asset sale-leasebacks and accounting for financial portfolios at market values.

If the rise in asset prices does indeed account for a big part of the decline in reported corporate leverage, then companies could be more vulnerable than investors think to an economic decline, especially if it were accompanied by weak financial markets.