When I was a Chief Financial Officer (CFO) our growth was dictated by a formula known as the "sustainable growth rate" formula. Basically our growth was restricted by the amount of profit that was added to the retained earnings at the end of the year. Retained earnings is a category of Owner’s Equity in the company. Secondarily growth could be enhanced by improvement of asset turnover. For instance, if you sold $50 million a year of inventory and kept $10 million of inventory in stock, your turnover rate is 5. If you could reduce your inventory to $7 million and still maintain enough to satisfy customer demand, your turnover rate would exceed 7. You would free up $3 million to help grow the business. The sustainable growth rate formula took into account these factors in determining how fast we could expand the business. Another factor was the debt to equity ratio. If we had liabilities of $4 million and Owner’s Equity of $2 million, our ratio was 2. Our bank watched these ratios as we did. If we could increase our leverage thus expand our assets and liabilities by $4 million, then our debt to equity ratio would be 4. Banks kept historical statistics by industry of acceptable financial ratios in order to compare the industry to our ratios. This was the way they did business 25 years ago. It is not important for you to understand the financial terms, it is important to understand that the financial institutions have had plenty of tools to monitor their lending practices.
By relaxing credit analysis standards you accelerate expansion of the economy at an increasing rate of change- Accelerator Factor. The sustainable growth rate formula restricted the rate of change of growth due to the consistent restriction of leverage. What is leverage? It is the use of borrowed funds to complete an investment transaction. The higher the proportion of borrowed funds used to make the investment, the higher the leverage and the lower the proportion of equity funds. We were restricted from growing our company too fast by over leveraging our assets. Why is this a problem? It is all about cash flow. Cash pays interest expense. Cash pays down the principal of you note to the bank. Cash "makes" payroll. Cash is the "oil" of the business to keep it running. Too much investment in non-cash assets works against the ability to repay debt.
There are three types of borrowers. The hedge borrower is one who can meet all his debt payments with cash. The second type is the speculative borrower who can meet interest payments but must constantly roll over his debt to be able to repay the original loan. The third type of borrower is the "Ponzi" borrower; he can repay neither the interest nor the original loan. This borrower relies on the appreciation of the value of his assets to refinance their debt. This type of borrower’s philosophy is a "greed" based philosophy. This borrower hopes that the asset will continue to appreciate forever. As long as his assets appreciates in excess of the original loan plus interest, he is in good shape. This borrower wears rose colored glasses. The sub-prime mortgage loans promoted this type of borrower. The lending institutions virtually created Ponzi borrowers by appealing to the "greed" factor. Why not buy a bigger house than you can afford? The problem did not stop there.
Financial institutions allowed hedge funds to "leverage up" their assets by 20 to 30 fold in order to achieve unbelievable returns for their investors. This avenue of lending raised the stakes of failure dramatically. This accelerated the growth of financial instruments and funded excessive growth in various sectors of the economy. The insatiable appetite of borrowers was welcomed by the lending institutions who threw out their "credit analysis" handbooks! CEO’S of these institutions received large bonuses based on the yearend profit results of the institution. Greed raised its ugly head again. The underlying motivation of the Accelerator Factor is greed. This motivation is the rocket fuel for the increasing rates of change in credit expansion through leverage. However, this is a two edged sword. The other edge is fear.
Once the market moves from greed to fear, the Accelerator Factor works in the opposite direction. The Leverage Factor is reduced and the balance sheets shrink at an increasing rate of change. Its like an accordion. The Fed and other central banks are now trying to manage fear. In the markets, fear tends to be a stronger emotion than greed, thus the ramifications of mismanaging fear on a global basis can have disastrous effects. Since in the history of man there has not been a similar financial environment to compare, those in charge are forging new territory. Are you ready to trust your financial future to them?
Federal Reserve Board Chairman Ben Bernanke pauses while discussing the near-term economic outlook during testimony before the House Budget Committee on Capitol Hill in Washington in this Thursday, Jan. 17, 2008 file photo. (AP Photo/Dennis Cook. File)