We all know the role of a CFO: the person whose job it is to make sure a corporation thrives financially. The CFO quarterbacks the balance sheet, looking at all assets and liabilities to determine the corporation’s optimal debt ratio. CFOs also look at risk of distress and its costs, factoring in the likelihood of a shock in the system and how much risk the company’s balance sheet holds.
It’s a delicate dance. If the company’s balance sheet is too risky, an economic crash means bankruptcy. But if carrying no debt could mean a liquidity crunch or vulnerable to a hostile takeover. Unlike companies, people tend to have way too much debt or no debt at all. There’s an incredible disconnect between something that almost all companies do and something that far too few wealthy individuals and families do or are even willing to think about.
Like companies, individuals need to manage their wealth holistically. They start with an assessment of needs, goals, and dreams, their immediate financial situation and the entirety of wealth. After this, they take into account everything from estate and retirement planning, to taxes, insurance and even end-of-life concerns. From here you (as CFO) methodically back out cash-flow needs and projections.
The advantage here is not limiting analysis and action to atomistic silos, where you make decisions on everything from buying a car to long-term investments without taking into account the impacts on your wealth’s entirety. Instead of getting a car loan to buy a Mercedes, a boat loan to buy a Hatteras, and a student loan to pay for Harvard, you consider how everything interacts with everything else, on levels from the most general to the most detailed.
CFOs look at the whole balance sheet and design around the risks and costs associated with distress. They don’t say, “Hey, I think I’ll issue $100,000 of bonds today. That might work out pretty well.” It’s an exact science with clear mathematical reasons with no guesswork. When the company needs cash to buy new desks, it doesn’t issue bonds specifically to pay for them. Have you ever bought a GE “desk bond?” Likely not.
CFOs also never take on amortized loans. Virtually all publicly traded American corporations issue debt on an interest-only basis because CFOs know that having any required payments on debt decreases flexibility and ultimately increases risk and cost of financial distress.
How many S&P 500 companies issue AAA bonds? A room full of advisors often believe the number is somewhere between 50 and 150 companies.
The answer is three.
Companies like Coke and Walmart make a strategic choice not to be AAA. Could these big, wealthy companies pay off all their debt if they wanted to? Of course they could! But they don’t and they won’t because they consciously choose to have an optimal amount of debt. The optimal corporate capital structure is between BBB and A-.
Most companies keep debt ratios between 30 percent and 70 percent, depending on the industry and their costs of financial distress. That’s way too high for individuals. Yes, Walmart could be more risk-averse because 1 million people will lose their jobs if it goes bankrupt. If a client goes bankrupt it affects only their family. Who’s more important? The client’s wife’s and kids’ needs are a lot more important to them, and you as their adviser, than those of Walmart employees. They feel the direct hit and need a debt ratio much lower than corporations. We recommend individual debt ratios in the 15-35 percent range—essentially about half that of companies.
How do corporations manage their debt ratios over time? A room full of advisors will have a mix of answers whether corporate debt ratios are higher or lower today than 1980. Some say it’s higher because interest rates in the high teens discouraged borrowing in the early 1980s. Others say that it’s lower because in 1980 things were going pretty well and corporations felt comfortable taking on debt.
The answer is that they’re about the same. Corporations have maintained constant debt ratios over time.
If corporate assets are higher than they were 30 years ago (clearly) how is this impacting total debt outstanding? It’s higher as well. Corporations choose to take on more debt over time to keep their debt ratios constant.
Individuals tend to start with high debt ratios and attempt to solve that problem by paying down debt. Most individuals drastically pay down debt then build assets once their debt ratio is around zero. But while they’re massively paying down that debt they’re ignoring asset growth, typically until five to 10 years before retirement when they have to scramble to “catch up.”
It’s crazy when you think about how differently the two act. Individuals aren’t companies and may not be primarily focused on making a profit. But they are an organized system of inputs and outputs that absolutely relies on having sufficient financial resources at the ready, just like a company. And when it comes to making money, companies know what they’re doing.