SUDDENLY, balance sheets matter.
For the last decade, as the American economy prospered, corporate America focused almost exclusively on earnings. Even as profits soared, however, many companies were borrowing more and more.
Why the debt? You might think that companies would have sought to take advantage of high stock valuations by selling shares and building up cash reserves. But few did. As a whole, corporate America bought more stock than it sold during the final years of the economic boom.
Buying back stock seemed like such a good idea. Companies could issue millions of options to their executives, and then buy back stock to avoid diluting earnings. Many borrowed money at relatively low interest rates and bought back more shares than they issued. That tactic raised earnings per share and persuaded investors that companies were growing when their revenues and overall profits were not. Wall Street loved it.
"One of the hazards of the boom in equities is that it made companies feel they were worth more than might have been supported by fundamentals," said John Lonski, the chief economist of Moody's (news/quote). "So they felt more confident about borrowing."
And borrow they did. By the second quarter of this year, corporate America had debts amounting to a record 28 percent of assets, noted Paul Kasriel, the chief economist of Northern Trust (news/quote).
Some called such numbers irrelevant. Interest rates were low, so debt- payment burdens did not seem excessive. Debt levels were compared with the high market value of companies' shares, and called reasonable. Earnings looked good, especially after companies massaged them to create pro-forma reports that left out some expenses. Investors who doubted those numbers looked instead to operating cash flow. Neither the earnings nor the cash flow table reflected the cost of share buybacks, and neither showed what would happen if sales, and share values, fell sharply.
Even now, earnings statements will present the best possible picture. The accounting rule makers have rushed out generous guidelines about how to treat losses after the terrorist attack. The rules are so flexible that some losses that would have been realized in any case will now be classified as extraordinary. Some companies will be able to report pro-forma profits that are better than they would have been without the attack. Analysts will say companies exceeded expectations, and thus presumably did well, even as they report large (extraordinary) losses.
It remains to be seen whether those numbers will reassure share buyers. But creditors will watch the balance sheet, where all losses, whether or not they are called extraordinary, look the same. Some companies may report good pro-forma earnings even as they file for bankruptcy.
Much of the commentary on the stock market since the attack has focused on which industries will be hurt the most by the recession and falling consumer confidence. But attention is gradually turning to the question of which companies have the strongest balance sheets, and thus will be best able to survive. This week's stock market recovery has been concentrated in higher quality companies.
As investors flee the junk-bond market, borrowing costs are up sharply for low-rated companies that can still borrow money. Many cannot.
Companies that go broke will blame the recession for their woes. But their complacent financial strategies during the boom will bear part of the responsibility.