Leverage and bad debts

Some 20 years ago, after a couple of senior management jobs, I was sent off to study for a month at the IMD business school in Switzerland.

There I spent time with Prof Jim Ellert, a noted financial analyst, who showed us how to understand a P&L and a balance sheet. He also passed on several powerful lessons about how to run, and not to run, a business.

His major lesson was about the danger of leverage. His demonstration was very simple, using standard assumptions for interest costs and tax, and stays with me today:

No leverage. In a good year, a company’s earnings might rise 30%, or fall 10% in a bad year. Return on equity (ROE) would swing from 18% to -6%. Nothing earth-shattering there.
50% debt ratio. Then in a good year, ROE would hit 30%, but be -18% in a bad one. Things could get tricky.
90% debt ratio. In a good year, ROE would hit a fabulous 126%, but in a bad year would be -114%. The company would be bankrupt.

The seeming genius of many private equity funds in recent years has been due to nothing more than the application of high leverage during the ‘up’ part of the business cycle. As and when we go into the ‘down’ cycle, leverage will exert its same impact on the downside.

If I was a CEO preparing my cost-leadership programme for rollout next month, I would include strict guidelines about how to manage credit risks with highly leveraged customers. Cash before delivery is an excellent principle, if one wants to avoid one’s own company being hit by a string of bad debts.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. The aim of this blog is to share ideas about the influences that may shape the chemical industry over the next 12 – 18 months. It will try to look behind today’s headlines, to understand what may happen next in important issues such oil prices, economic growth and the environment. We may also have some fun, investigating a few of the more offbeat events that take place from time to time. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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One Response to Leverage and bad debts

  1. Keith Simons 17 August, 2007 at 3:53 pm #

    Paul,

    Very interesting! As I’m unlikely to get sent to the IMD, is there any chance of a worked example to show how the numbers fall out?

    Keith

    Keith, I’ll be delighted to send you something. Paul

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