Debt/asset and debt/equity ratios should really be used in conjunction with interest support measurements, like times-interest-earned, to measure how leverage has changed. Unfortunately, that’s a level of detail not really feasible for a comment on a blog post.

Furthermore, the data I typically work with is firm-level data, but I’m simply talking in aggregates here. So, yes, on average firms’ leverage has gone down (albeit slightly), as cash holdings (among large firms) have increased. This appears to be in response to higher volatility of operating income. The tax regime hasn’t changed enough to reorder firms’ priorities.

Now, regarding the timing issue: this is important for individual firms. In an aggregate sense, I think the timing issue would tend to wash out, as assets and debt get replaced over time. So the trends in leverage should be reasonably accurate. The leverage (long-term debt/total assets) ratio tends to be 0.18 – 0.2, but the lowest one is 0 and the highest is around 1.3, so there is considerably cross-sectional differences.

Debt/asset and debt/equity ratios should really be used in conjunction with interest support measurements, like times-interest-earned, to measure how leverage has changed. Unfortunately, that’s a level of detail not really feasible for a comment on a blog post.

Furthermore, the data I typically work with is firm-level data, but I’m simply talking in aggregates here. So, yes, on average firms’ leverage has gone down (albeit slightly), as cash holdings (among large firms) have increased. This appears to be in response to higher volatility of operating income. The tax regime hasn’t changed enough to reorder firms’ priorities.

Now, regarding the timing issue: this is important for individual firms. In an aggregate sense, I think the timing issue would tend to wash out, as assets and debt get replaced over time. So the trends in leverage should be reasonably accurate. The leverage (long-term debt/total assets) ratio tends to be 0.18 – 0.2, but the lowest one is 0 and the highest is around 1.3, so there is considerably cross-sectional differences.

I’m not sure what that will tell you. As I see it, the distortion for debt ratios is caused by assets and debt on the books being acquired at different periods. If the book values of assets represent sums paid for those assets many years earlier – and the debt refers to debt acquired relatively recently – then the ratio of debt to assets is distorted. That has been exactly the case at large companies at which I’ve worked. Debt was extended to us not on the basis of the book value of assets but rather on the income producing ability of those assets, many of which were already fully depreciated.

I’m not sure what that will tell you. As I see it, the distortion for debt ratios is caused by assets and debt on the books being acquired at different periods. If the book values of assets represent sums paid for those assets many years earlier – and the debt refers to debt acquired relatively recently – then the ratio of debt to assets is distorted. That has been exactly the case at large companies at which I’ve worked. Debt was extended to us not on the basis of the book value of assets but rather on the income producing ability of those assets, many of which were already fully depreciated.

On the second point: I’m not sure where my head was at. It is obvious that lower denominators result in higher ratios. Thank you for pointing that out.

When I get a minute, I’ll deflate the total assets and long-term debt by the PPI (or would CPI be better?) and see what that tells us. Incidentally, did the Fed paper deflate market values by CPI or PPI?

On the second point: I’m not sure where my head was at. It is obvious that lower denominators result in higher ratios. Thank you for pointing that out.

When I get a minute, I’ll deflate the total assets and long-term debt by the PPI (or would CPI be better?) and see what that tells us. Incidentally, did the Fed paper deflate market values by CPI or PPI?

I don’t thinik that is correct, neoaustrian. Are you referring to U.S. federal taxation of corporations? Here’s a primer on tax treatment of business interest expense.

neoaustrian: “This serves to bias debt ratios downwards, however, rather than upwards, because the denominator is artificially low.”

I agree that inflation makes the denominator artificailly low. That was the point made by me and by the economists of the New York Fed. If the denominator is artificially low, the debt ratio is thus artificially high. That was the case in the high inflation period of the 1970′s and early 1980′s.

I don’t thinik that is correct, neoaustrian. Are you referring to U.S. federal taxation of corporations? Here’s a primer on tax treatment of business interest expense.

neoaustrian: “This serves to bias debt ratios downwards, however, rather than upwards, because the denominator is artificially low.”

I agree that inflation makes the denominator artificailly low. That was the point made by me and by the economists of the New York Fed. If the denominator is artificially low, the debt ratio is thus artificially high. That was the case in the high inflation period of the 1970′s and early 1980′s.

Second is the use of market value. Capturing a balance sheet item at any given time using market value can be distortionary because the market value at any given time could be significantly different from the true (unknowable) value of the firm. So, if one is using market values, one must use a long-run average to try and balance out distortions. I didn’t read the Fed paper, so I’m not sure if or how they address the issue.

I see the Fed paper used total debt. The concern in this article is about the tax differential, so total debt is not the correct metric. The reason is that total debt includes short-term debt (like notes payable) and trade credit (accounts payable). Interest on these items is not tax deductible, and/or these items are tactical rather than strategic. Long-term debt interest is tax deductible, and long-term debt is a strategic item, so it is considered to be a corporate strategy decision of executive management.

Now, to return to the issue of book assets: inflation is definitely a concern here, because replacement values of assets will, on average, be higher than historical costs. This serves to bias debt ratios downwards, however, rather than upwards, because the denominator is artificially low. The other thing is that net capital expenditure (capital expenditure – depreciation) is positive for the most part during this period. This indicates that most firms are replacing assets as they wear (sp?) out, so that total assets are not likely to be extremely far from replacement value.

Second is the use of market value. Capturing a balance sheet item at any given time using market value can be distortionary because the market value at any given time could be significantly different from the true (unknowable) value of the firm. So, if one is using market values, one must use a long-run average to try and balance out distortions. I didn’t read the Fed paper, so I’m not sure if or how they address the issue.

I see the Fed paper used total debt. The concern in this article is about the tax differential, so total debt is not the correct metric. The reason is that total debt includes short-term debt (like notes payable) and trade credit (accounts payable). Interest on these items is not tax deductible, and/or these items are tactical rather than strategic. Long-term debt interest is tax deductible, and long-term debt is a strategic item, so it is considered to be a corporate strategy decision of executive management.

Now, to return to the issue of book assets: inflation is definitely a concern here, because replacement values of assets will, on average, be higher than historical costs. This serves to bias debt ratios downwards, however, rather than upwards, because the denominator is artificially low. The other thing is that net capital expenditure (capital expenditure – depreciation) is positive for the most part during this period. This indicates that most firms are replacing assets as they wear (sp?) out, so that total assets are not likely to be extremely far from replacement value.

The trade-off theory of corporate finance suggests that firms choose their debt ratios by balancing the tax benefits of debt financing with the potential costs of bankruptcy. The presence of large depreciation charges reduces the tax benefits of debt, as do investment tax credits.

The pecking order of finance posits that firms prefer internal financing, then debt financing, and then equity financing last, due to the negative signals equity financing sends.

While most tests of leverage choices by firms are difficult and open to interpretation, the pecking order theory tends to hold up better. This is consistent with the debt being a governance substitute, as John Dewey pointed out.

In short, while this disparity in financing costs is large, it appears to be of secondary importance to most corporations and so not as big of a concern here as the effect of corporate tax rates on capital formation in the first place.

The trade-off theory of corporate finance suggests that firms choose their debt ratios by balancing the tax benefits of debt financing with the potential costs of bankruptcy. The presence of large depreciation charges reduces the tax benefits of debt, as do investment tax credits.

The pecking order of finance posits that firms prefer internal financing, then debt financing, and then equity financing last, due to the negative signals equity financing sends.

While most tests of leverage choices by firms are difficult and open to interpretation, the pecking order theory tends to hold up better. This is consistent with the debt being a governance substitute, as John Dewey pointed out.

In short, while this disparity in financing costs is large, it appears to be of secondary importance to most corporations and so not as big of a concern here as the effect of corporate tax rates on capital formation in the first place.