Does equity remove the need for credit? Or just allow for lower interest on credit?

Hello, fellow PoliticalForum.com members! I’m a newbie here on the forum and after some browsing I can see that this is a thoughtful, diverse, and intelligent crowd. I’m looking forward to our future discussions!

So… I have an economics question, and am hoping that those here with greater knowledge will chime in and enlighten me!

To keep it short I’ll leave out the details, but basically I was reading about some businesses that entered into crisis due to very high debts they couldn’t repay. The author said the reason for their debt crisis was because none of them had equity and so any investments (either to expand the business or improve the technology used) required credit.

This confused me, because even if a business has equity, won’t it still need credit? As far as I understand it, the only advantage of equity is that it allows you to get credit with a lower interest rate. But the issue of needing credit is not avoided!

So what do you think? Was this just clumsy wording by the author? Or is there some way that having equity allows you to invest without needing credit?

Thanks a million!

 

Let's start with definitions to make sure we're talking about the same things:


Equity: the value of an ownership interest in property, including shareholders' equity in a business


Most people know this from their home loans where their equity is the difference between the value of the home and the amount remaining on their mortgage loan. This type of value is typically illiquid.


Credit in a nutshell can be a loan of which the duration and terms can vary greatly.


The author is correct, if you have enough equity to back your transactions, in times of crisis you can dip into that value to pay for expansion, but that's typically not done. The reason it isn't done is because expansion and capital investments typically lead to greater revenues, so the business is basically thinking: "If the interest rate is lower than the return on the investment it'd be wise to pay for it with credit." Having more equity hedges you against the risk of investments not having the returns you were expecting. Equity doesn't remove the need for credit, but reduces the risk associated with it.

 

Another factor, when a business purchases capital equipment, it has to be depreciated over years. Even with a short 3 year depreciation 66.7% of the purchase price is taxed as profit, so even more cash is required (35% tax on 66.7% requires an additional 23.34% - significant, an additional 33.25% is required on a 20 year depreciation.

A credit purchase doesn't require saving the purchase price + the tax, so the equipment (and the resulting productivity) can be purchased sooner, and the interest on the loan is deductible.

 

It was not a problem of equity so much as a problem of liquidity. There are many firms that operate with high ratios of debt to equity but have no problem with financing their operations because they maintain enough liquid assets, i.e. cash and other easily convertible instruments, to service whatever debt obligations they have as they come due.

Equity is a very nebulous term. There is market equity which is the value of all the outstanding stock of a firm. There is another measure of equity which consists of the value of all the property that the company holds, including land, buildings, machinery, intellectual property and things like good will and brand. When Sears was taken private the value of its land and buildings considerably exceeded the price of all its outstanding shares.

In the crises of 2009 many firms found themselves short because the money market seized up and they were unable to take short term loans to do things like make their payroll or pay vendors. This was because they did not have enough liquid assets, i.e. cash. It is also one big reason why US companies are now sitting on over $2Trillion in cash.

 

Hi there! I just want to thank all of you for responding and describing your insights.

This makes sense for the context of what I was reading about. It was describing some businesses in Israel during the 1980s when there was an economic crisis with inflation rates as high as 400%. In that case then the interest rates are certainly NOT going to be lower than the returns! So are you saying that with equity to dip into, they could have gotten loans at way lower interest? And how much lower is it, typically? Or perhaps there's no interest to pay when you borrow against your own equity?

 

In times of high inflation you want to get rid of cash as quickly as possible and take on as much debt as you can because money today is worth less tomorrow. Just by staying in business you will reduce your companies debt ratio because income will rise with prices while debt will not. That said, banks are not very willing to lend on anything but the shortest term in times of high inflation, or if they do, will demand astronomical interest rates.

An exception is that businesses with a lot of export income can leverage their foreign earnings to induce local banks to lend them money in return for foreign currency deposits, which they would be desperate for to shore up their balance sheets as returns on their fixed loans plummeted. In a small economy a business could gain enough leverage that the bank would make loans at negative interest, in other words paying the business to place its foreign receipts with them, which would allow the bank to maintain its balance sheet as it dealt with the inflation.

In more normal times a businesses equity to debt ratio, debt to income ratio, and cash position are the prime determinates of its creditworthiness though other market factors often play a part. Equity, while a big factor, cannot be used as a sole determinate in reaching for conclusions, or explanations.

 

The answer to your question is somewhat controversial. Different people will emphasize different answers.
My belief is that there was too much imaginary wealth, and too much was borrowed to begin with. You see, just because your business could be sold for some amount of money does not mean it can be sold for that much. Ever heard of the fallacy of composition? Suppose there are 100 houses in the same area, exactly the same. One of them just sold for 300 thousand dollars. Does that mean the 100 houses together are worth 30 million dollars? No. Because as you start selling some of them, the price of the rest will go down. And yet, the bank who was lending money was acting like each one was worth 300 thousand. See the problem? Banks mistook market price for worth. They are not the same.

So in my opinion, the answer is NOT to lend out more credit. That is just propping up bad loans. As you may be able to tell, I completely disagree with economists who think the financial system needs to be "stabilized", or that interest rates need to be artificially held down.

The problem is the liquidity of the equity. But if the equity was sufficiently large in proportion, theoretically the business would not need credit. But most people would still call it "credit".

Makes you wonder, if they did not have sufficient equity, should the bank have really loaned them money? Because in that case, it would become more of a risky investment than a loan.

 

I don't get this debt based economy at all.

I grew up old school back in the day when if you wanted to get a loan, you had to prove that you didn't need it.

Debt is the same as slavery.

Do whatever it takes to stay out of it.

My philosophy is the same a Willie Shakespeare.

"Neither a borrower or a lender be"

 

Tell that to those that crafted the tax laws. You are punished for saving and rewarded for borrowing, especially as a business.

I expect the rules were political payback to the bankers.

 

Of course the system is fixed to encourage as many people as possible into debt slavery.

That's a wet dream for the ruling class.

 

What do you mean by the liquidity of the equity? I know that liquidity means how easily an asset can be converted to money. So is taking a loan out on the equity of the house you own an example of liquidity?

 

No, it is debt secured by property. Your ability to sell the home, and pay that debt if need be is the liquidity problem with real estate. If you had public stock, and could sell it in a day it has a high liquidity. If you have stock of a small closely held private business you have low liquidity because you have to go out and talk someone to buying you out. The ability to sell the house at a price higher then your current debt is your liquidity problem, the easier that is, the more liquid your house, the less likely it is, the less liquid.

 

In a time sense, not a return on the price. The chance of you getting the price back is risk.

 

I fully concur with your statement as I to was brought up old school.

But if you want a captive audience lend them money.... You have them by the economic balls!

Regards
Highlander

 

It depends. Debt has made me a lot of money.. not a lot in libber terms, but enough for me to live comfortably in America with my used cars, bargain house and craigslist furniture. The decision to take on debt has to be measured by the pros and cons, too often people forget the cons, and make a bad decision of the potential benefits and risk.

 

The economy does not operate on the exchange of money so much as the promise of money. Only retail cash transactions fall into the category of direct exchange, most other exchanges, and the vast majority of exchanges in the economy are promissory. I will pay you later for what you have given me today.

Manufacturers do not pay their suppliers cash on the barrel. Suppliers understand that the manufacturer may need to make some products and sell some of them in order to generate the cash to pay them. There is an implicit understanding that the money will be paid in some agreeable period because they understand cash flow. So they send invoices that are payable in 90 days, or 30 days, or upon receipt or on other terms depending on their perception of the trustworthiness of their sales partner to pay them. As often happens a manufacturer may find themselves with the sales but payment may come later than the time on the invoice to pay their supplier. Faced with a cash crunch they need to borrow some money.

This is why lending is so valuable to an economy. If every person and business had to wait until they had the cash on hand to pay for everything they need there would be a lot less going on in the economy, by orders of magnitude.

 

The Amazon business model is to also make money on the interest of immediate payments, until the bill is due in 90 days. That is an advantage over most store fronts that must maintain inventory, which may never sell.

Suppliers don't want to be lenders as well, the terms are 90 days - same as cash, for companies with a good credit rating. Loans are someone else's business.

I don't think by orders of magnitude. Most companies make less than 10% in profit, therefore interest costs are significant.

Taxes are more significant than debt. Extra cash is used to grow the business. Loans are used to buy the capital equipment, so they don't have to pay tax on the "profits" needed to buy that equipment.

 

In the case of a business, their equity is based on 2 things. 1) Intrinsic assets (Building, equipment, vehicles, etc.) 2) Profits and losses. P&L can be capitalized based on historical, contemporary and future marketing outcomes/plans although this incurs the most risk to any lender so interest rates would naturally be higher. Securing a loan by encumbering real assets would be the most straight-forward as the lender could repossess in the case of a default.

 

That is a loan no matter what you think it is.

Most companies have uneven cash flow but more predictable recurring costs, like payroll. There are a few ways to deal with this. One is to always maintain a large amount of ready cash, another is to arrange a line of credit which can be tapped when cash runs low. A third way is to borrow short term. Keeping large amounts of cash around to smooth over cash flow is a very inefficient way to deploy assets. Arranging a line of credit can be fraught with high costs and other problems even if it is rarely used.

Borrowing short term is a lifeline for many companies. The collapse of the money market in 2009 is exhibit A for how short term lending keeps the economy running as companies like IBM and HP and GM were suddenly unable to borrow from the money market to meet their payrolls or pay vendors. If the government had not stepped in with ad-hoc short term lending the economy would have lost millions more jobs.

Debt is a significant part of running a business of any size. Short term borrowing and lines of credit are used to smooth over cash flow. Long term debt in the form of loans and corporate bond issues are used, along with reinvested profits to pay for capital improvements. The issue of new shares can also raise capital.

The whole idea is to keep the money moving because it is the velocity of money that drives the economy. Sitting on cash dies not create economic activity. If enough people and corporations decide to sit on their cash because they think they need it to smooth over their cash flow the economy will stagnate, just as it is now with corporations sitting on over $2Trillion in retained profits. This is not necessarily to blame them since they are doing so in part because of the collapse of the money market in 2009, which left many of them precariously short of cash, but the withdrawal of that much money from the economy does have its effects.

 

Thank you to the new responders to questions! I appreciate it.

 

I agree if you have the ability to pay for the debt incurred.

Most don't have job security, and as the are in the majority little is to be gained by an individual or nation for that matter but the finance sector have everyone by the economic balls and can dictate to everyone, and the are not an elected body.

Regards
Highlander

 

I agree, and it also matters what the debt is for. I try to take it on only when the chances I are high I will get it back from what I am spending it, or get enough savings to cover the interest on the loan or make it worthwhile. For example, I get a 10% discount on hosting if I pay the year in advance, so it pays to pay that with a credit card that has a 0% interest promo the first year. Then I just pay it as I would monthly, just 10% less, and make sure the card is paid off before the end of the year. Problem is, most people spend debt on the personal products they want, but cannot afford. That is dangerous.