© 2000 John Petroff

4)- Unleveraged industry types

Among the sectors presented in Table T-10.3, the sector that relies the least on debt is the manufacturing sector since it has the highest equity to total assets ratio with 38.5%. In several manufacturing industries (such as relays, cans, dresses, overcoats, brick tiles, optical equipment, dental supplies, oil field machinery, medical chemicals and electronic components), the majority of firms (big and small) financed more than 50% of total assets with equity in 1999. These statistics confirm the proposition offered in this chapter that financial leverage should not compound a firm's risk when it already has a high operating leverage. Indeed, in addition to carrying large fixed assets, firms in these industries engage in research and development which should not be financed with debt.

We conclude this chapter with a few tests of other propositions formulated above. First, let us test whether there is a correlation between the size of fixed assets and the proportion of equity. One may argue that financing fixed assets with equity (E) is safer and wiser. Using average proportions of equity and fixed assets to total assets for eight US sectors, a regression on FA = a + b E gives an R2 of 0.05 and establishes that there is no correlation between fixed assets and equity. It was argued that sales instability dictates avoidance of excessive financial leverage. Sales instability (SI) is assigned a rank from 8 to 1 for the eight sectors in Table T-11.16 below on the basis of the standard deviation of the rate of growth of components of personal consumption expenditure shown in Table T-14.2.

An OLS regression on equation E = a + b SI gives an R2 of 0.34, a coefficient b of 0.36 and a t statistic for b coefficient of 1.75. An OLS regression on equation LTD = a + b SI gives an R2 of 0.15, a coefficient b of -0.11 and a t statistic for b coefficient of -1. On the basis of these very aggregate numbers it would seem that theory is somewhat supported, especially in the case of use of equity.

The fear of bankruptcy dictates that firms maintain a sufficient operating profit to cover interest expense, or putting it the other way around, that firms avoid interest expense that cannot be covered many times by operating profit. Times interest earned (TIE) ratio is reported in Table T-11.16 below for the eight sectors. An OLS regression on equation TIE = a + b SI gives an R2 of 0.00, and an OLS regression on the equation TIE = a + b LTD gives an R2 of 0.05. This shows that at an aggregate level interest coverage does not appear to be a consideration in corporate strategy when it comes to dealing with sales instability or long term debt.

How reliable are conclusions drawn from comparison of one firm with the industry? To answer this question, one can look at the dispersion of average equity statistics measured by the standard deviation in the eight US industries presented in Table T-11.17 below.

Table T-11.17 shows that the standard deviation of equity proportion is the largest among firms in the service and information sectors which includes software developers and computer service companies. This dispersion suggests that there is no clear strategy or planning in the face of the difficulties mentioned previously. The sectors with the least dispersion of equity to total assets ratios are in construction and wholesale sectors. This suggests that most firms follow a best practice strategy in these two sectors. One would suspect that these sectors would also be the least difficult to analyze.

See review questions Q-11F4.1 through Q-11F4.4.

See research assignment R-11F4.1.

Previous: 3-Leveraged_industries

Last modified: Jun/01/01

Next: Readings