The level of leverage in quoted companies and its relation to various economic factors

An accepted index of an economy’s macroeconomic and financial stability is the extent of leverage among firms in the private sector or, in other words, the scope of activity that is financed by liabilities other than internal sources. A study done at the Bank of Israel examined the trend in leverage among publicly traded companies in Israel for the period 1995–2006 and the relative importance of various factors in explaining it.
The main findings:

* Publicly traded companies preferred to finance their activity through debt and 
   this tendency became more pronounced during the sample period. Thus, 
   average leverage (defined as a firm’s ratio of liabilities to balance sheet assets)
   rose from about 55 percent in 1995 to about 65 percent in 2006.
* Publicly traded companies chose to increase their leverage primarily by issuing
   bonds on the Tel Aviv Stock Exchange. The financial reforms, whose
   implementation accelerated at the beginning of the decade, enhanced nonbank 
   financial intermediation in the provision of credit to the business sector and
   encouraged the growth in bond issues.
* The level of leverage was characterized by significant variation between firms
   according to industry. For example, real estate companies used debt to finance
   their activity to a much greater extent than the average for all industries while 
   investment and commercial companies chose a level of debt that was somewhat
   higher than average.
* A set of ten variables, out of a group of more than thirty that were chosen, was
   found to be significant in explaining the variation in level of leverage between
   firms. Thus, for example, it was found that larger, more stable and faster-
   growing firms chose a higher level of leverage while firms with high operating
   profit tended not to distribute their profits as dividends and thus increased their
   internal sources of financing and reduced their level of leverage.

The issue of leverage in a firm and its determinants have occupied researchers and policy makers for many years. It is well known that a moderate level of leverage is desirable and that a high level of leverage increases risk. Leverage provides the firm with additional sources of financing and contributes to accelerated growth in its activity over time. However, too high a rate of leverage, given the need to repay the debt, increases the vulnerability of firms in the business sector to shocks, such as an unexpected decline in demand or a sharp increase in the rate of interest, which is liable to reduce their ability to repay debt.

A high level of leverage also has serious macroeconomic and systemic implications, such as an increase in the risk of bankruptcy, increased costs of finance (and as a result reduced investment) and the restraining of business sector activity. A high level of leverage is liable to worsen an economic slowdown and to reinforce negative shocks. Finally, large debt payments reduce a firm’s liquidity and reduce its ability to invest in worthwhile projects and as a result can hold back economic recovery.

The study carried out by Ran Sharabani and Adi Azulai of the Bank of Israel looked at the trend in leverage among non-financial publicly traded firms in Israel and its determinants during the period 1995-2006. The study used four different definitions of leverage and gathered its data from quarterly financial statements (with a total of more than 20,000 observations). The study found a set of ten variables, from within a list of more than thirty, which were significant in explaining a large portion of the variation in leverage among firms.
Of these ten, the main explanatory variables were found to be: operating profit – a profitable company tends to preserve its profit in order to increase its internal sources of financing and reduce its level of leverage; size of the firm (measured by total assets) – a large and/or long-established company, which in general enjoys easier access to cheap debt, tends to have a higher level of leverage; growth – a fast-growing firm is characterized by a high level of investment and tends to finance its investment plans with debt and therefore will have a higher level of leverage; the firm’s risk characteristics – a firm with less stable profitability will benefit less from the tax benefit of debt financing and in addition debt financing will be more expensive for it; therefore it will tend to choose a relatively low level of leverage; and the industry to which the firm belongs – the table below presents the level of leverage according to industry. During the period 1995-2006, real estate companies had a higher than average rate of leverage while electronics and chemical companies financed their activity with an average level of leverage.

The results obtained by the study are in general consistent with those predicted by the trade-off theory of capital structure. According to this theory, a company decides on its optimal level of leverage according to the trade-off between the tax savings from debt-financing and the risk of bankruptcy due to difficulties in servicing debt. Some of the results were also consistent with the pecking order theory, which holds that firms issue shares only as a last resort after exhausting their ability to obtain debt financing. The study also found that factors which affect the leverage decision are somewhat similar for both Israeli and US firms.