RDP 9216: The Evolution of Corporate Financial Structure: 1973–1990 1. Introduction

Increases in corporate debt over the past decade have increased interest in the determinants of corporate financial structure and the relationship between financial structure and the business cycle^[1]. This increased interest follows a period in which issues related to corporate financial structure received little attention. On the micro-economic front, this lack of attention was due, in large part, to the work by Modigliani and Miller (1958). They argued that, under certain conditions, the optimal financial structure of the firm is indeterminate and should not influence the firm's real decisions. On the macro-economic front, there was little interest in the relationship between corporate finance and the business cycle following the work of Friedman and Schwartz (1963). Their results on the correlations between output and money led to a preoccupation with money as the financial factor responsible for the business cycle.

The view that financial structure does not matter has recently come under considerable attack. This, in part, reflects concern over the macro-economic effects of the increase in corporate leverage that occurred in a wide range of countries during the 1980s. There have also been considerable advances at the theoretical level. In particular, models emphasising management incentives and principal-agent problems have formalised links between financial structure and economic activity^[2].

While there has been considerable empirical exploration of the links between financial structure and the business cycle in the United States, there has been little work done using Australian data. This paper is a first step towards filling the gap. It uses a recently constructed database to examine changes in the financial structure of Australian firms over the past two decades. The database consists of financial statement data for 224 firms over the period 1973 to 1990. The data derives from records kept by the Reserve Bank of Australia as part of its production of the Company Finance Supplement. In turn, the Reserve Bank of Australia's records are based on data published by the Australian Stock Exchange and data supplied by firms to State Corporate Affairs Bureaux.

The paper has two specific goals. The first goal is to document changes in the structure of corporate balance sheets and financing behaviour over the past two decades. We examine changes in the leverage of firms, their interest cover, their dividend payment policy and their reliance on creditors^[3] as a source of debt finance. The second goal of the paper is to examine the variation in financial structure within different industries. In particular, we explore the issue of whether changes in financial structure have been concentrated in industries that are particularly sensitive to the business cycle.

While changes in the average leverage of firms may have important implications for the behaviour of the economy in response to a particular shock, it is also important expansion, most were to examine the distribution of leverage across firms. For example, the extent to which the macro-economy becomes more vulnerable to shocks, following increased indebtedness of the corporate sector, is likely to depend on the characteristics of the firms whose leverage rose. Increases in the debt-asset ratios of firms with stable cash flows could be expected to have less adverse effects than increases in the debt-asset ratios of firms with volatile cash flows. Similarly, the ability of the economy to rebound quickly from a recession may be adversely affected if increases in leverage are concentrated in firms that have highly cyclical output. For such firms, an economic downturn causes a significant deterioration in their ability to meet current obligations out of current earnings. This may make it more difficult for these firms to finance positive net value projects and may make risk-averse management unwilling to undertake risky investments. The result is a deeper recession and a slower recovery than would have been the case had leverage been lower. Lowe and Rohling (1993) discuss this issue in more detail.

In this paper, changes in the distribution of leverage across firms are explored using two different methods. First, for each year, we rank the firms by their leverage and then observe the leverage at specific percentiles of the distribution. We then examine changes in those percentiles over time. Applying the alternative method, we rank industries based upon the degree of volatility or cyclicality of their output and profitability. We then examine the relationship between the degree of cyclicality/volatility and the changes in leverage of the firms in particular industry groups. These techniques are also applied to the other ratios that have been used to describe financial structure.

The results in this paper indicate that leverage increased strongly throughout the 1980s, after having remained fairly constant during the 1970s. It shows that, at least until 1987, the increase was widespread throughout the corporate sector. From 1987 onwards, however, the majority of firms reduced or maintained their level of gearing. Of the firms that did continue with strong debt expansion, most were already highly geared^[4]. Associated with the generalised increase in leverage during 1980s was an accelerated growth rate of firms' balance sheets. However, earnings growth did not fully cover the increased interest burden generated by the rise in debt. As a result, interest cover was much lower in the 1980s than in the 1970s.

Finally, the study of financial structure by industry shows that the rise in leverage was a characteristic of all industries, regardless of the degree of their volatility or cyclicality. However, the extent of the financial structure adjustment differed considerably across the industries examined. The results suggest that the adjustment was relatively pronounced in the manufacturing sector that is also the most cyclically sensitive sector examined. In contrast, the less cyclically sensitive retail and services sectors experienced smaller increases in leverage. They did, however, have higher initial leverage than did the manufacturing sector.

The remainder of the paper is structured as follows. Section 2 describes the database, defines the ratios examined in the paper and explains the statistics used to summarise movements of the ratios. Section 3 then discusses the evolution of the ratios over time and examines changes in the frequency distributions of the ratios. In Section 4, the relationship between cyclicality and volatility on the one hand and changes in financial structure on the other, is examined. Finally, Section 5 summarises and concludes.

Footnotes

See Stevens (1991) and Dempster, Howe and Lekawski (1990) for earlier discussions of the rise in leverage in Australia. [1]

Gertler (1988) provides a useful summary of this work. [2]

“Creditors” is defined as the sum of “trade creditors” and “other creditors” as reported in the Company Review Service. [3]

Extending the database to include data for 1991, a subsample of 66 firms showed a continuation of this pattern. Many firms appeared to be reducing their leverage while others experienced increased leverage. The limited data available for 1992 suggests that, during 1991/92, more significant and generalised reconstruction took place. [4]