Leverage and bad debts
on August 17, 2007

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: equity. Then in a good year, ROE would hit 30%, but be -18% in a bad one. Things could get tricky.
• 90% debt? 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.

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  • Keith Simons
    August 17, 2007

    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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