For What It's Worth: The Debt/Worth Ratio

Introduction:?It Ain’t Exactly Clear

Buffalo Springfield probably did not have financial ratios in mind when they sang these lines from For What It’s Worth almost 60 years ago:[i]

“There's something happening here

But what it is ain't exactly clear

There's a man with a gun over there/worth

Telling me I got to beware . . .”

Our banking regulators do not carry weapons yet, but they often do warn us to beware of borrowers with too much debt and too little worth.?Wary lenders employ the debt-to-worth ratio to identify risky borrowers who leverage their equity into acquiring more debt, and Warren Buffett has observed, “When you combine ignorance and leverage, you get some pretty interesting results.” Yes, and may your overleveraged borrowers live in interesting times.[ii]

The debt-to-worth ratio’s origins and rise to fame and stature among financial measures is interesting reading in these interesting times of leveraged lending, so let us explore its history further.

Wealth and Debt in Reasonable Proportions:?He Ain’t Heavy, He’s My Brother

In 1943 Boys Town’s Father Flanagan was reading a magazine in which he saw an older boy carrying a younger boy on his back in a photo captioned, “He ain’t heavy, mister, he’s my brother.”?It reminded the Father of another boy at BoysTown in 1918 who carried a polio-ridden boy on his back.?When Father Flanagan asked the boy if carrying the younger boy was hard, the boy replied, :He ain’t heavy, Father, he’s my brother.”?Father Flanagan asked the magazine for permission to use the image and the quote, and Boys Town adopted them both to define its new brand.[iii] ?If only there was some redeeming quality in lenders loading borrowers with too much debt.?Equity and debt may be sources of capital, but they are not brotherly expressions of brotherly love.?Don’t think Don and Phil Everly or John Belushi and Dan Aykroyd as the Blues Brothers; more appropriate would be at-odds brothers like Cain and Abel or Romulus and Remus.?Too much debt may be more than its brother equity can handle.

In their 1928 text, Ratio Analysis of Financial Statements, Wall and Duning explained that economists describe wealth as useful things with value, so the wealth of any company is represented by its assets, the things it owns.?These assets have value and can be exchanged for other things or money.?An enterprise must have some wealth, or capital, with which to start a business.?Factories must be built or erected, materials or merchandise purchased for fabrication or for trading.?Anyone who wishes to engage in business as a manufacturer or as a merchant must have something with which to begin, something to exchange for the things needed to start the business.?However, as the business grows, the initial owner’s capital gets used up and while waiting for inventory to be sold and receivables collected, the owner is pressed to search for temporary capital from other sources.?After all, net worth and debt both represent capital at use; the first is owned outright, and the second is loaned temporarily by another owner who at maturity may withdraw his willingness to remain an economic partner and ask the return of the loaned capital.?When a business’ volume has reached the point that it must continually use someone else's capital?to support that volume, it has taken the first step toward a “top-heavy condition.”?When the disproportion has expanded so much that withdrawal of this?outside capital would wreck the business, then the company is?fatally top-heavy with debt.?Owned capital or net worth may support borrowing in some reasonable proportion, but a continuing top-heavy proportion is a sure indicator that management will not be able to earn itself back into a position where it will be able to generate enough cash flow to repay debt and relieve itself of its reliance on outside capital.[iv] ?Written nearly a century ago, Wall and Duning laid down a straightforward rationale for evaluating and monitoring the debt-to-worth (D/W) ratio—watch out when the borrower’s debt load can no longer be repaid.?One wonders if the agency analysts ever read these words as they hand out BBB and CCC ratings to heavily indebted corporations while admitting in small print that repayment is only possible in stable or improving economic conditions.

The Long View:?Putting Off Until Tomorrow What You Cannot Pay Today

Mark Twain mused, “Never put off till tomorrow what may be done after tomorrow just as well.”?Lender and borrowers seem to have heeded this advice, because after the turn of the century, the D/W ratio became more complex as long-term debt made its way into the balance sheet’s liabilities.?Dun & Bradstreet’s Roy Foulke chronicled the arrival of long-term debt in his First Edition 1945 Practical Financial Statement Analysis ?as railroads issued bonds to finance their growth during the 19th Century.?By January 6, 1900, there were 758 bond issues of 346 railroads listed on the New York Stock Exchange.?Sometime during the last quarter of the 19th century, Foulke noted that:[v]

“ . . . the conception arose that the typical commercial or industrial business concern should not have liabilities in excess of its invested capital, that is, its tangible net worth. At this stage in our economic development relatively few enterprises, except railroads, had long-term liabilities such as mortgages, bonds debentures, or serial notes. . . Such a situation would mean that all creditors, for their own protection, should have no more at stake in a particular endeavor than the owner or the owners of that enterprise.?That seemed a reasonable pragmatic proportion . . . and credit men . . . would cut down their extension of credit when a balance showed liabilities exceeding this very definite and recognizable limit.”

Foulke advanced D/W ratio analysis in two ways.?First, he distinguished between leverage from short-term and long-term debt, arguing that a firm with all its debt current faced more immediate debt pressure than a firm with most of its debt classified as long-term debt.?Second, he advocated the use of tangible net worth to get a more realistic measure of equity.[vi] ?Owner’s equity is really a shock absorber, anyway, to the extent that net worth represents a cushion for creditors against shrinkage of assets.?For example, a company with $1,000,000 in total assets and $600,000 in net worth might suffer a $600,000 loss in value of its total assets but still have $400,000 left to pay off the creditors’ $400,000 in claims.?However, if the company had intangible assets, e.g., goodwill, trademarks, copyrights, patents, and other intellectual property, valued at $250,000, the presumption is that these assets have no value in liquidation, so the company really has only $750,000 in tangible assets.?Therefore, analysts routinely deduct intangible assets from the $600,000 book net worth to arrive at $350,000 intangible net worth (TNW).?In this case, the D/TNW is $400,000/($600,000-$250,000) or $400,000/$350,000 = 1.6x, far more leveraged than the initial but overly optimistic D/W ratio at $400,000/$600,000 = 0.67x.?

Finance textbooks eventually took on the challenge of the right proportion of debt to equity.?Financial institutions—commercial banks, insurance companies, investment bankers—evolved conservative standards of debt capacity for given industries.?Borrowers also looked at the debt policies of comparable companies although this approach transfers the responsibility for the appropriate risk to one’s competitors, but others argue that the debt practices of an industry reflect a pooling of extensive experience and widely accepted decision rules are time-tested guidelines.?Further, investors compare a company’s debt levels with the industry, and if the company is out of line, it may be penalized in the capital market.?Standards such as a 30% of capitalization rule began to emerge, i.e., long-term debt comprising 30% of the sum of long-term debt and equity, and the tax-deductibility of interest expense made debt a viable option for reducing the overall cost of capital.?One text acknowledged that D/W ratios varied from industry to industry depending on the reliability and stability of cash flows.?Utilities could afford more debt because if their customers refused to pay their bills, then they would lose their electricity, gas, water, etc.?On the other hand, retailers had far less control over their customers, and changes in fashion and taste introduced more volatility and less stability into their cash flows; hence, their lenders would be more reluctant to advance as much debt compared to utilities.?Even so, D/W ratios for manufacturers in 1965 ranged between only 0.17 and 0.48, according to the SEC.[vii]

According to British banker, Roger Hale, we employ the D/W ratio to see how much the business is built on owner’s capital and how much on other people’s money:[viii]

"There’s an old saying that?OPM + PMA (other people’s money plus a positive mental attitude) leads to riches.?As a lender, you want to know the extent of the risks borne by your bank and other lenders compared with the risks carried by the owners.?Other people’s money is always fine for the smart operator, but as a member of the ‘other people’ who provide the money, you must be concerned with the extent to which you and the other lenders bear the risks and the smart operator gets the rewards.”

Hale admits that the D/W ratio has flaws—the measure ignores cash flows, book values of assets are never realized in liquidation, and not all the liabilities are shown on the balance sheet, e.g. contingent liabilities.?However, he argues that D/W ratios are useful in ranking competitors in a given industry.?The financially strongest will be the least leveraged and so have?more ability to undertake bold moves?in strategic terms.?On the other hand, highly leveraged firms have less room to maneuver because mistakes might weaken their financial condition.?He concludes that the more debt a company has, the less it is able to make independent decisions. Hale’s book includes a Business Week October 1978 chart of debt ratios for selected US industries showing these aggregate averages:[ix]

????????????????????????????D/W ratio??????????0.61

??????????????% short-term debt??????????5.5%

??????????????% long-term debt????????????32.3%

??????????????%net worth??????????????????????62.2%

The mystery is why the D/W ratios in Hale’s book and in other sources reported here are so low.?Maybe the data reflects publicly traded companies, and perhaps years ago, their lenders were more conservative.?It does suggest that times have moved on, and today’s leverage ratios may reflect more tolerance by lenders of high debt loads as well as the competitive marketplace for debt among commercial banks, investment banks, insurance companies, private equity funds and other non-financial lenders.?

There are two primary sources of industry leverage statistics, the Annual Statement Studies published by the Risk Management Association[x] , and IBISWorld’s industry financial ratios[xi] ?.?Both report on the D/W ratio but derive their information from different sources.?RMA data comes from member banks submitting financial information on current borrowers, so its statistics tend to reflect results of creditworthy borrowers; RMA also reports upper and lower quartiles as well as the median, so users can gauge how on or off the mark their prospective borrowers may be.?For example, electrical contractors might have an upper-median-lower D/W industry ratios of 0.9-1.7-3.5, and a bank with a borrower whose D/W ratio of 0.7 know its borrower’s D/W ratio ranks in the upper quartile.?RMA’s D/W ratio is actually a D/TNW ratio.

IbisWorld’s ratios are drawn from a wider base of firms in a given industry; it uses IRS SOI Tax Stats and the US Census Bureau. IBISWorld has estimated this data at the industry level from these aggregated sources. Its data is likely to include both bankable and nonbankable companies, but the data results in statistics more reflective of all the firms in a given industry.?Further, it D/W ratio is based on book net worth, not TNW.

Banks may shy away from some industries, e.g., pawn shops, title lenders, gambling operations, marijuana distribution, so those industries might be underreported or have too few financials to offer any statistics.?Therefore, IbisWorld may be an alternate source.?Investors may compare RMA and IbisWorld statistics and derive some estimate of the risk premium inherent in the differences between a creditworthy electrical contractor’s D/TNW ratio and the IbisWorld D/W ratio, e.g., 0.7 vs. 1.2.?Are bankers passing up business opportunities that other lenders might find doable?

Summary and Closing:

Comedian Henny Youngman used to say, “You can’t buy money with happiness,” so be happy to have some cash whether owned or borrowed.?Lenders have been happy to use the debt/worth ratio to figure out how much happiness they want to extend to borrowers.?The D/W ratio ignores cash flow, questionable assets, and unreported liabilities, but its long use makes it a useful tool for gauging the relative proportions of debt and equity a business needs and wants.?The D/W’s size has increased over time, but that may simply reflect that both lenders and borrowers are more comfortable with more debt, especially as debt has expanded into long-term funding to ease immediate debt pressure from current liabilities.?Industry data from various sources, including RMA and IbisWorld, offer some benchmarks for comparison with a borrower’s industry.?Oscar Wilde recalled, “When I was young, I thought money was the most important thing in life.?Now that I am old, I know that it is.” Finance has matured enough to recognize the importance of money to successful firms, whether their own or other people’s money.?Use the D/W ratio to maintain a balance between the two sources.

[i] For What It's Worth (Stop, Hey What's That Sound)," often referred to as simply "For What It's Worth," is a song written by Stephen Stills. Performed by Buffalo Springfield, it was recorded on December 5, 1966, released as a single on Atco Records that month and peaked at No. 7 on the Billboard Hot 100 chart in the spring of 1967.?It was later added to the March 1967 second pressing of their first album, Buffalo Springfield. The title was added after the song was written and does not appear in the lyrics.?In 2004 Rolling Stone magazine ranked the song at number 63 on its list of the 500 Greatest Songs of All Time.?(https://en.wikipedia.org/wiki/For_What_It's_Worth )

[ii] ‘May you live in interesting times’ is widely reported as being an ancient Chinese curse, but according to the Phrase Finder website (www.phrases.org.uk ), it was originally said by American politician, Frederick R. Coudert in 1939.

[iii] The Story Behind “He Ain’t Heavy…” June 9th, 2017????By Father Steven Boes | President and National Executive Director of Boys Town, ( https://www.boystown.org/blog/Pages/story-behind-aint-heavy.aspx ? )s_src=google_grants&s_subsrc=cpc&s_src=google_grants&s_subsrc=cpc_google&gclid=Cj0KCQiAic6eBhCoARIsANlox84uliRHJtXj3-QBZTsXDZcBxE9g0_8D_rkWw99161El844hEo4-znwaAnkBEALw_wcB

[iv] Alexander Wall and Raymond W. Duning, Ratio Analysis of Financial Statements:?An Explanation of a Method of Analysing Financial Statements by the Use of Ratios, (New York City:?Harper & Brothers, 1928), pp. 118-123.

[v] Roy A. Foulke, Practical Financial Statement Analysis, Fifth Edition ((New York City:?McGraw-Hill Book Company, 1961), p.208.

[vi] Ibid.

[vii] Pearson Hunt, Charles M. Williams, and Gordon Donaldson, Basic Business Finance, Third Edition, (Homewood, Illinois:?Richard D. Irwin, Inc.,?1966), 382-8.

[viii] Roger H. Hale, Credit Analysis:?A Complete Guide, (John Wiley & Sons:?New York City, 1983), p. 87.

[ix] Ibid., pp. 86-91.

[x] For more information, go to www.rmahq.org or to https://www.rmahq.org/statementstudies/?gmssopc=1

[xi] For more information, go to https://content.ibisworld.com/media/4yng4fwx/technical-notes-understanding-industry-financial-ratios.pdf