Last year the average household debt stood at just over £66k and is set to rise for as long as the cost-of-living crisis continues. Similarly, many small business owners have been taking on more debt than they would otherwise feel comfortable with just to keep the lights on. For them, it is about surviving the storm until more prosperous times return. Whether you’re a private individual or a business owner, the principal of owing money doesn’t change, but the causes and justification for debt are as infinite as the stars themselves. Here we’ll take a look at how business and national debt can be better represented as a statistic instead of a number followed by a bunch of alarming zeros.
Barometers of Debt
Gearing provides a measurement of business debts expressed as the ratio of loans and long-term liabilities to shareholders’ funds and equity. For example, if a company had liabilities of £400k and equity of £200k, it would have a gearing ratio of 200%, making it highly leveraged. An ideal debt ratio falls between 25-50%, but it varies between industries. Liabilities aren’t just loans, mortgages, and creditors. Companies can and do tap investors for funds by offering bonds with an enticing interest rate. In effect, the bond holder loans the company money over a given period for a set interest rate.
The Debt-to-GDP ratio expresses national debt as a percentage of Gross Domestic Product. If the debt is £2bn and GDP is £1bn, then Debt-to-GDP is 200%. The ratio is similar in principle to Gearing, except GDP is used in place of equity. GDP and national debt act as a barometer of economic health and the stick from which to chase a failing Chancellor out of Downing Street. When the UK borrows money, it doesn’t go to your high street bank or payday loan company. It goes to the ‘markets’ or, in other words, sells bonds to pension funds, insurance companies and corporate investors at an attractive interest rate offering very little risk. The UK has never defaulted on bond payments.
Analysts and investors use Gearing and Debt-to-GDP to help assess the risks in lending and the probability of default.
Let’s Talk Gearing!
Historically the financial sector is highly geared, but this is misleading because banks borrow vast sums to then loan out. Capital-intensive industries like aviation, transport, energy and telecoms can exceed 100% without causing alarm. Debt should be looked at against the backdrop of industry standards and individual business traits. Low gearing is no guarantee a company won’t collapse tomorrow, and high debt levels don’t necessarily mean investors and suppliers should run for the hills.
At last available (approx.) figures, IT software giant Oracle had liabilities of $75bn; luxury German car marque BMW owed $87bn; Shell Plc $89bn; General Motors $110bn; Amazon and Apple were at over $115bn each with Deutsche Bank breaching $150bn. For a bit of perspective, take a look at Japanese conglomerate Softbank Group with assets and cash of $100bn going some way to offset debts of $160bn. Toyota Motor Corporation has debts surpassing $190bn against a backdrop of annual revenues exceeding $200bn. Do we think Shell, Apple or Toyota are going to call in the liquidators any time soon? It’s highly unlikely but not impossible.
Let’s Talk Debt-to-GDP!
Going back to the notion of national debt being a proverbial stick from which to hasten an incumbent Chancellor’s demise, much has been made of the UK’s debt in recent years. Chancellors gloat when running a budget surplus and are less vocal when in deficit. History buffs will know Britain’s part in the Napoleonic wars of 1803-1815 came at a huge financial cost. It increased debt to approx. 250% of GDP before the Second Treaty of Paris signalled the end of hostilities. This remains the highest debt-to-GDP ratio on record, but the £679mn of the national debt in 1815 looks tame compared to the billions owed by your Apples and Deutsche Banks of today. The only other times our debt-to-GDP ratio has been anywhere near 250% was WWI and WWII. From 1961-2020 national debt stayed below 80%, falling to 21.7% in 1991. The economic downturn of 2020-2021 saw debt peak at 120% of GDP. For the same period, France hit 138%, Greece 224%, and Japan topped the list at 259%. In stark contrast, Luxembourg, Denmark, Sweden, New Zealand and Switzerland all ran below 60% and are still amongst the least indebted nations. At the start of 2023, UK debt was sitting at 99%, equating to £2.5tn and growing at £5.7k per second!
Like most economies, the American government borrows from the markets to make up any shortfall between IRS collections and federal expenditure. It is the world’s most indebted country, now owing over $31tn for the first time in history. Yet the debt-to-GDP ratio is at a tame 148%. Those of you with an appreciation for American politics will know that if Congress fails to agree on a federal budget, the resultant government shutdown places all but key workers on furlough. Shutdowns are also triggered when the debt ceiling is reached and Congress cannot gain consensus. Think of it as a self-imposed credit limit. Since its introduction in 1917, the debt ceiling has been raised no less than 115 times. Maybe it is a reflection of the modern world, but the ceiling has been suspended six times since 2013 to avoid America defaulting on its loans.
(Alternative) Theory of Relativity
If you’ll entertain the word fascinating, then one of the fascinating things about debt is that it is relative. By that, we mean it is relative to income, expenditure, assets, and one’s peers. Place America’s $30tn of debt with the UK’s GDP, and you’ve got bankruptcy. Place the UK’s £2.5tn debt with America’s GDP, and you’ve got a superhero’s balance sheet. If GDP shrinks and the monetary value of debt remains the same, the debt-to-GDP ratio skyrockets. If a company undervalues or overvalues its assets, gearing will not reflect a true and fair view. For household debt, the same relative thinking applies. If you have an income of £750k and debts of £250k, then all is good. But when you have an income of £7.5k and debts of £250k, you’d be considered, in smart speakers, ‘attached to another object by an inclined plane, wrapped helically around an axis!’.
In commercial debt recovery, we look at gearing, revenue, and long-term and short-term liabilities to decipher if the debtor lacks the means or motivation to pay. That gives us a base on which to both understand the debtor and decide what tools will be most effective in recovering payment. All instructions, large and small, are held up to the same assessment because the principal of owing money and your right to recover it remain unchanged.