The Importance of Strong Balance Sheets

Summary

• A new Bank of England working paper explores how short-term debt accumulation affects the three-year ahead investment growth of US firms.
• The author finds the investment growth implications depend on whether a firm is financially vulnerable and the source of financing.
• Overall, firms with highly liquid assets, low outstanding debt, and debt financed mainly via the market (rather than bank loans) experience increases in investment after credit booms.

Introduction

A review of the financial crisis literature finds crises characterised by excessive household debt have significantly worse medium-term growth implications than those involving corporate debt. This is because, unlike household debt, corporate debt can normally be restructured and liquidated quickly. However, just like households, large run-ups in debt can significantly hinder a firm when looking to fund future investments.

And so, a new Bank of England working paper asks whether corporate debt booms can also, on average, affect medium-term growth prospects. The author uses a large panel of listed US nonfinancial firms from the mid-1980s to 2019 and categorises debt vulnerability by (a) the debt accumulation speed, (b) firm leverage, and (c) and asset liquidity. The paper finds:

• Corporate debt booms come with weaker future investment over a three-year horizon, but financially vulnerable firms drive the slowdown.
• This is because these firms face higher borrowing costs, preventing them from financing their investments in fixed assets and intangible assets.
• Also, the financing source matters, with bank loan build-ups having larger negative implications for investment than market debt.

Motivation: Evidence on Debt Booms and Investment Growth

The link between debt and GDP growth has been studied extensively. Evidence from recent downturns shows leverage tends to spike just before recessions, then declines substantially after. Another, less documented, feature is that debt booms typically coincide with investment growth slowdowns (Chart 1). That is, investment growth starts to slow roughly two years before the debt boom peaks, and only starts to recover one year after.

Facilitating this link is probably debt’s disciplinary role on investment decisions. For example, in addition to any default risk, highly leveraged firms cannot raise more debt to finance new projects because the profits are earmarked for existing debt holders, not the new investors. Indeed, post GFC, research found firms with higher pre-crisis debt experience weaker investment afterwards.

However, the BoE paper argues that the constraining role of debt accumulation is very specific to each firm. It depends on the speed of debt accumulation, the leverage ratio, and the liquidity of the firm’s assets. Accounting for this heterogeneity should show which firms are more likely to see investment growth fall around credit booms, and whether those with healthy balance sheets are also penalised.

Methodology and Data

The author uses quarterly data from Compustat. The final sample includes balance sheet information on 4,742 US nonfinancial listed companies from 1985 to 2019. Firms are split into three equal bins of leverage and liquidity at each point in time. The author measures leverage as the book value of total debt, and liquidity as current assets (cash and short-term investments, receivables, inventories, et al.) net of current liabilities (short-term debt, accounts payable, income taxes payable, et al.).

Subsequently, the author defines firms with low debt/liquid assets as those belonging to the first tertile of the respective sample distribution, moderate debt/liquidity to the second tertile, and high debt/liquidity to the third tertile. Based on this definition, firms with high debt are typically larger, have limited liquid assets, and record the lowest capital spending growth in the sample. These firms also have higher default risk and have experienced large swings in debt build-ups over previous decades (Chart 2).

For method, the author uses Local Projections to estimate the relationship between corporate debt build-ups and investment spending. Lastly, they define debt booms as periods when the three-year change in the corporate debt ratio is above its sample standard deviation.

Results

First, aggregating across all firms, corporate debt build-ups are associated with weaker future investment spending – a 10pp debt increase comes with lower investment of around 1.2% during the subsequent five years. Corporate credit booms also lead to higher borrowing costs. On aggregate, evidence suggests large accumulations of corporate credit negatively affects the real economy.

Breaking down the results by firm-level characteristics shows firms with few liquid assets experience lower future investment following a corporate credit boom. Dividing leverage by liquid asset holdings, firms with high debt relative to their liquid assets also suffer a larger decline in investment spending following debt build-ups.

Next, the author looks at medium-term investment in firms that are both highly indebted and illiquid. That is, those belonging simultaneously to the top tertile of the leverage ratio distribution and the bottom tertile of the liquidity ratio distribution. Intuitively, they are the most vulnerable firms in the sample. These firms tend to have negative liquidity asset holdings and face high corporate financing costs. They also experience large swings in debt accumulation, while non-vulnerable firms have much smoother credit cycles (Chart 3).

The analysis shows a 10pp increase in debt build-ups in vulnerable firms results in lower investment of 4.6% after four years. Also, for every 10pp increase in the pace of credit accumulation, vulnerable firms reduce their investment spending growth by roughly 2.5pp more than other firms after five years. Therefore, both the speed and size of debt accumulation matters for investment growth after credit booms.

For resilient firms, i.e., those with low outstanding debt and liquid assets, investment increases in the aftermath of a corporate credit boom. In other words, debt accumulation improves the investment outlook of firms with healthy balance sheets. This is likely because they can easily fund a cashflow shortfall and, therefore, negative shocks affect them less.

The research then asks whether the source of funding affects the investment growth contractions of vulnerable firms. Indeed, the author finds debt accumulation from bank loans is significantly more likely to reduce future investment than market debt. Meanwhile, there is no evidence the accumulation of short-term debt has any more negative implications on investment than long-term debt.

Lastly, the author examines how debt booms impact long-run productivity growth/intangible capital growth. Like the capex results above, financially vulnerable firms also face weaker intangible capital growth. On the other hand, debt build-ups in unconstrained firms make for higher productivity growth up to 12 quarters ahead.

Bottom Line

Capital expenditure and productivity growth drive long-term economic prosperity. Following credit booms, which typically occur around recessions, only firms with the healthiest balance sheets have good investment outlooks. Meanwhile, financially vulnerable firms will see future investment growth fall, especially if they have large outstanding bank loans.

All-in-all, the paper highlights the important link between a firm’s balance sheet and its long-term investment potential. Those firms accumulating debt rapidly, and with fewer illiquid assets, will inevitably reach a point where the associated debt overhang will hinder their access to future loans. On average, two years before this point, investment growth will decline and continue to fall sharply thereafter.

Citation

Albuquerque, B., (2021), Corporate debt booms, financial constraints and the investment nexus, Bank of England, (Working Paper 935), https://www.bankofengland.co.uk/working-paper/2021/corporate-debt-booms-financial-constraints-and-the-investment-nexus