July 18, 2010
Lever UP! Applying the Debt/Equity ratio to the US Government
This is a read for financial fanatics like me…
The term “Lever UP” is a term used by mostly investment bankers/politicians when they’re considering using leverage (or in other words – debt) to expand, increase profits, or to cover an entity’s operations. Using leverage requires great discipline of the individual, corporation, or government entity that chooses to borrow money for whatever purpose. Unfortunately, it’s easy for a person or an organization to easily have bad judgment in determining how much leverage he/she can manage…and I wonder if the United States is misjudging its ability to contain its debt woes.
The CIA World Factbook is constantly updated every 2 weeks with intelligence and information about various governments around the world. Concerning the United States, the CIA World Factbook states the following:
“US firms are at or near the forefront in technological advances, especially in computers and in medical, aerospace, and military equipment; their advantage has narrowed since the end of World War II. The onrush of technology largely explains the gradual development of a "two-tier labor market" in which those at the bottom lack the education and the professional/technical skills of those at the top and, more and more, fail to get comparable pay raises, health insurance coverage, and other benefits. Since 1975, practically all the gains in household income have gone to the top 20% of households.” “Long-term problems include inadequate investment in economic infrastructure, rapidly rising medical and pension costs of an aging population, sizable trade and budget deficits, and stagnation of family income in the lower economic groups.”
Take, for instance, an over-leveraged corporation that has an unsustainable amount of debt and in order for it to maintain just the interest payments on the debt it has incurred – it must raise its prices and reduce employee benefits (expenses) by cutting its healthcare benefits, reduce salaries, and engage in massive layoffs.
Does this sound familiar? Does it remind you of our government? Where we are embarking on trillions of dollars in debt!? From a governmental standpoint, where a government is over-leveraged, it will (or it should) raise its taxes (i.e., Government will be dramatically raising taxes beginning 2011) and cut healthcare entitlements such as Medicare and Medicaid (i.e., Both of these programs are severely underfunded), it will cut Social Security payouts (i.e., Trustees estimate this will be bankrupt by 2037), and have temporary high unemployment (i.e., Currently the unemployment rate is at 9.3%).
Let’s consider the United States’ debt/equity ratio (I replaced the word company with [government] for purpose of this article):
Investopedia.com states - A debt ratio of greater than 1 indicates that a [government] has more debt than assets, meanwhile, a debt ratio of less than 1 indicates that a [government] has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a [government]’s level of risk.
The United States has a GDP of $14.26 Trillion as of 2009; nevertheless, we also have $13.45 Trillion in debt owed to other countries. Which equates to a debt ratio of $13.45t/$14.26t = .94 !
A high debt ratio is explained by Investopedia.com
A high debt/equity ratio generally means that a [government] has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
If a lot of debt is used to finance increased operations (high debt to equity), the [government] could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the [government] generates on the debt through investment and business activities and become too much for the [government] to handle. This can lead to bankruptcy, which would leave shareholders with nothing.
What do we do?
It seems not to matter what your political party may be, because Democrats and Republicans alike seem to increase the debt of this country. Everyone is out for self-interest before they consider other’s interests. So we have to be financially responsible for ourselves – no matter what’s going on in Washington.
So, protect your self-interests….my advice is the same as it always have been – I would advise people to get out of debt, invest a portion of your wealth in commodities such as silver and gold, oil, real estate, etc. Establishing a retirement plan just with paper dollars is a huge risk – so those of us who are considering retiring with a 401K and/or Social Security might be putting too much risk into paper dollars and on the capability of his/her government. It’s time to consider some alternative assets.
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Does a dollar and a dream count as alternative assets? Seems like 6 numbers would be a good investment plan. Just kidding. Good stuff as always.ReplyDelete
Hi Barrington. Good article. Thematically, I don't disagree with any you stated in the article. I think you might be substituting a debt service ratio (debt service / revenue) with the D/E ratio (total debt/total equity).ReplyDelete
Your right. I cannot find a D/E ratio (total debt/total equity). It's probably so close to zero that its meaninglessDelete