How Much Debt is Too Much?

Auto Focus: How Much Debt is Too Much?
MiBizWest • July 18, 2001
by Jim Gillette

I recently pointed out to a group of auto component company senior executives that the majority of their middle managers were too young to have been in decision-making positions during a protracted downturn in auto sales. The last recession ended in the spring of 1991; the decline in sales actually began during the late 1980s. Managers with less than 13 years experience have never been through a complete cycle.

The old adage is a cliche but true, that almost anyone can man­ age a business in good times while it takes experience and skill to weather a downturn. While times are not nearly as tough for the auto industry today as they were in “real” recessions (take 1980 to 1982 for example – now that was a real recession!), it takes a deft hand at financial management to keep most firms solvent.

About 25 percent of suppliers in stress

As of this writing, the recent demise of Mexican Industries is the latest indicator of the increasing fragility of the North Ameri­can auto supply industry. While it is difficult to take a precise reading because most firms are privately held and do not publicly re­lease their financial statements, there is an­ecdotal evidence that as many as 25 percent of North American automotive component suppliers are currently experiencing finan­cial stress. There have been several business failures to date and there are surely more to follow.

Businesses fail for a vari­ety of (usually a combination of several) rea­sons. A com­mon element is nearly always too much debt for internal and external cir­cumstances. Firms that are all-equity fi­nanced can voluntarily cease operations, but cannot be forced into bankruptcy by non-existent credi­tors.

The smooth ’90s

Ironically, many compo­nent suppliers may have ac­quired excess debt as the re­sult of the exceptionally good times during the 1990s. The graph on this page illustrates that the U.S. auto industry enjoyed an unusual period of relative stability during that decade. During the prior 30 years, managers had to con­ tend with year-over-year swings in vehicle demand that were as much as three times as large as in the 1990s. And you can note from the graph that we have been and still are on a solid growth trend in sales.

Such an extended period of prosperity likely seduced both bankers and business owners into a false sense security that the cyclicality of the auto industry had been significantly damped.

On the surface, it is true there is less volatility in total vehicle sales. Two factors, however, are offsetting the benefits of rela­tively smooth demand to suppliers. First, as I have noted in previous editions of this column, the traditional Big 3 have lost con­siderable market share. Suppliers with a sales mix disproportionately weighted to­ ward the Big 3 have suffered revenue de­clines accordingly. Second, price reduction demands from the automakers in excess of suppliers’ ability to reduce costs have squeezed margins and cash flows.

The key to keeping your firm’ s head above water lies in evaluating the sources of risk.

Sources of risk

There are two fundamental types of risk faced by any company: business risk and financial risk. Business risk itself has two sources. The type of business, the products/ services offered and markets served deter­ mine the first. Some businesses are inher­ently more cyclical than others. Proctor & Gamble’s disposable diaper sales, for ex­ample, are relatively insensitive to year­ over-year swings in the economy. People will continue to have babies through good times and bad (barring a major economic catastrophe like the Great Depression of the 1930s when births fell dramatically).

The auto industry, on the other hand, is a classic example of a cyclical business. Be­ cause vehicles are durable goods, consum­ers are able to delay purchases by up to several years if their personal economic circumstances prevent them from buying a new car during a recession. There is often also the option of buying a less expensive used car.

The second source of business risk re­sults from the amount of fixed cost versus variable cost required to manufacture a prod­uct or provide a service. This is called “op­erating leverage.” The higher the operating leverage, resulting generally from fixed as­set investmnent, the greater the probability that a business will not be able to cover its fixed costs during a sales slump.

Here again, the auto industry is more at risk than the average business. Most manu­facturing activities related to auto compo­nents are capital intensive. As I pointed out in “Evaluating Capital Expenditures In A Tight Market” (MiBizWest, 3/28/2001), the automakers have been pushing responsibil­ity for capital investment off to their suppli­ers over the last several years.

Financial risk results from funding a busi­ness with debt versus equity. Because debt is a contractual obligation, interest and prin­ciple payments must be made regardless of whether or not the firm has positive cash flows. Debt financing is also referred to as “financial leverage.”

Businesses that experience a large amount of business risk have found it prudent to limit their level of financial risk. The com­bined use of operating leverage and finan­cial leverage certainly can lead to super returns for owners during boom times. But, a mix of both high operating and high finan­cial leverage is a dangerous combination for cyclical businesses. Yet, in many cases, this is apparently exactly what transpired during the latter half of the 1990s in the auto com­ponent industry.

Some evidence

Looking at Standard & Poors long-term debt rating criteria for industrial firms, in order for a firm’s debt to be considered “investment grade” (BBB or better), the basic EBIT interest coverage ratio needs to be in the range of approximately 3.9 times or higher. Speculative grade debt (BB or lower) exhibits basic interest coverage of 2.3 times or lower.

As of December 2000, the EBIT interest coverage of a broad-based group of North American publicly-held suppliers stood at 3.4 times – in the fuzzy zone between invest­ment grade and speculative. For a group of over 300 auto suppliers tracked by the Risk Management Association for the most re­cent accounting period (ending 3/2000), the median interest coverage was 3.2 times, again in the fuzzy zone. The worst 25 per­ cent had a median interest coverage of only 1.2 times, having fallen steadily from their 1995 level of 2.5 times. In other words, a drop in EBIT of little more than 20 percent would put these firms in a position that operating income would not even cover required interest payments.

Determining how much debt your firm can reasonably handle does require that you take a critical and unbiased look at how much “business risk” you are already carry­ ing. Then consider that the 1990s were an anomaly with only minor cyclical fluctua­tions. We probably won’t be that lucky in the future.