Corporate America looks well-positioned financially to support growth

As the post-pandemic recovery slows — and it inevitably will — talk in business and investment circles will turn to the timing of the next cyclical correction. It might then help to consider what could cause a recession.

On this front, two possibilities arise: One is a policy error, always a danger whether a Republican or a Democrat is in the White House. The second is the development of imbalances in the economy. This post offers some good news about how little financial risk exists in the corporate sector, and how nonfinancial corporations are in excellent shape to withstand a business shock and support an economic expansion.

Probably the most important sign of financial health lies in debt-to-net worth and debt-to-equity ratios. During the pandemic lockdowns and quarantines, concerns emerged that with a few significant exceptions profit shortfalls might force businesses to borrow more than was prudent. But the feared financial setback turned out to be minor and more quickly resolved than was generally expected. During the worst of the pandemic strictures, corporate debt rose from just under 31.5% of net worth in 2019 to a high of 45.8%. It has since fallen more than a third of the way back to 2019’s strength.

As of the first quarter of this year, the most recent period for which complete data are available, the debt stood at 42.9% of net worth. The debt-to-equity ratios show a more dramatic but ultimately more encouraging picture. During the worst of the pandemic, debt amounted to some 32.5% of non-financial corporate capital, up from some 30% in 2019. This debt dependence has since more than corrected and as of this year’s first quarter stood at only 20.6% of non-financial corporate capital.

Any setback in stocks, whether transitory or more significant, will, of course, weaken both these measures, especially the debt-to-equity ratio. That is an unavoidable consequence of the way the numbers are calculated. What is more important is how this limited reliance on debt stabilizes corporate finance. Were debt a larger part of corporate balance sheets, it would demand servicing in the event of a profits shortfall that could take a large enough share of what cash flow remained to force more borrowing or even bankruptcy. That the ratio remains low suggests that such an unpleasant event is remote at worst.

This picture of financial stability and resiliency brightens even further when considering how little corporate America relies on short-term borrowing. The greater the reliance on short-term debt, the greater the need to refinance frequently and consequently the greater threat rising interest rates present to the firm’s bottom line. In contrast, a greater relative reliance on long-term debt implies less need for frequent refinancing and so a less vulnerable bottom line.

During the pandemic emergency, business did rely heavily on short-term borrowing, which rose from some 49% of all debt in 2019 to 83%. But since, corporations have taken advantage of historically low bond yields to refinance those short-term borrowings with longer-term commitments from lenders. In this year’s first quarter, short-term debt fell to only 25% of all debt.  In this respect, too, corporate America is well positioned to weather shocks and certainly is not likely to prompt the kind of correction that could lead to a cyclical decline.

Yet another indicator of financial strength emerges in what some analysts refer to as the “financing gap.” This measures how much capital spending absorbs of a firm’s internally generated funds. According to Federal Reserve data, this figure moved into negative territory during this year’s first quarter. In other words, capital spending – on structures and equipment as well as systems and other intellectual property – fell below levels of internally generated funds.

This comparison speaks to enormous financial strength. It means that these corporations have the wherewithal to step up spending for expansion easily and quickly without any need for external financing. To be sure, this comparison raises questions about levels of confidence among corporate managers. Why in this boom are they so reluctant to spend and could the lack of capital spending impair long-term growth potentials in the broader economy.

For the longer term, there is ample reason to worry over the relative lack of capital spending. It could, indeed, show a troubling lack of confidence among business managers, perhaps from the prospect of tax hikes. But there is ample time for attitudes in the corporate sector to change and still provide the economy with the productive base it needs to generate acceptable growth rates.

The rest of this picture offers nothing but encouragement. Corporate America’s strong finances will enable it to cope with future shocks and, perhaps even more encouraging, provide assurances that the kinds of imbalances that cause cyclical corrections will not emerge from this sector.

 

This article was written by Milton Ezrati from Forbes and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.