The “Leverage Effect” and business distress

March 6, 2024
Written by Amar Pandya
The “Leverage Effect” and business distress

As published in Finance et Investissement on 6 March 2024 (in French), and Conseiller on 25 March, 2024.

There is a wide subset of different variables that can affect a business and lead it into distress. If these various factors were arranged within a pyramid structure, at the base, would be macroeconomic—the economic cycle, global/national growth, inflation, central bank policy, and the political backdrop which remain out of company’s control. Higher up the pyramid are industry-, and company-specific risks, including capital allocation decision including shareholder returns, acquisitions and the use of leverage.

The benefit of adding leverage is a company can reduce taxable income by deducting interest tax expenses, creating a tax-shield and amplifying returns if the cost of capital is lower than the potential returns that can be generated. But the trade-off is a higher probability of being in financial distress should things take a turn for the worse. Senior management is often incentivized through their compensation programs to add leverage with the potential for reaping asymmetric returns for business outperformance. This gives them a compelling reason to push leverage beyond the company’s optimal capital structure.

We saw this movie during the pandemic where, as one example, the airline industry was hit with an exogenous event that brought their revenues to zero. In the years prior to the pandemic the industry had benefitted from improved pricing power after decades of consolidation, new ancillary revenues (e.g. baggage fees, seat selection) and lower fuel prices, allowing them to generate billions of dollars in cashflow. Instead of keeping that cash in reserve for a rainy day, the airlines returned billions back to shareholders and further added leverage to amplify returns. When the pandemic hit, the industry was ill positioned to withstand the loss of revenue with expenses racking up and they needed to be bailed out to survive.

Enterprises which face a trifecta of risks from market, operational, and strategic headwinds have little room for taking on additional financial risk in the form of leverage. The typical corporate distress cycle moves from early impairment into stress (failure, insolvency, default), then bankruptcy with the possibility of a new company re-emerging from the ashes. Often this a gradual, then sudden, process. To quote from Ernest Hemingway’s novel The Sun Also Rises:

“How did you go bankrupt?”
“Two ways,” Mike said. “Gradually and then suddenly.”

The “gradually” phase provides potential investors with sufficient clues about a company’s current and near future state of health. There are many different tools which take either an accounting-based or market-based approach to identifying distress. Using accounting methods, investors can parse quarterly or annual financial statements using tools that score the company on such variables as liquidity, profitability, and solvency. The benefit of this type of approach is the data is comparable and easily accessible. Market-based models use market data which means there is no lag effect unlike using financial statements and the models can typically be updated daily. Market prices encompass a wide range of information which can enhance the power of prediction. A lot of market data is based on the volatility of the shares, bonds, options, and swaps of a company. The combination of employing both models can enhance analysis helping investors identify early signs of distress. In today’s market environment with high interest rates, market uncertainty and technological disruption, businesses can quickly face distress. Knowing the factors that contribute to distress and the early warning signs to identify distress in businesses can help investors avoid significant losses.


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