# That 'just right' debt-to-equity ratio.

A debt-to-equity ratio, which is the total debt of an entity divided
by the total equity of that entity, is a measure of the use of leverage
or a measure of risk. Leverage is the use of other people's money
to make money. In its simplest form, it is borrowing money from someone
at a stated interest rate (such as 8%) and then investing that money in
a project that earns a greater return than this stated rate (such as a
12% return).

Leverage results in great profitability--when it works--because an entity is earning profits without having to invest any of its own money to get that return. The greater an entity's debt-to equity ratio, the greater the use of other people's money to make money. The greater an entity's debt-to-equity ratio, the greater the opportunity for high returns for that entity.

The debt-to-equity ratio is also a measure of risk since the more debt that is used, the greater the risk that the entity might be forced to liquidate and go out of business. This is the case because although equity investors |owners~ will not attempt to put a company out of business, debtors might if the entity fails to make timely interest and/or principal payments.

What should a company's debt-to-equity ratio be? My answer has always been: It should be "just right." By "just right," I mean it should be high enough where the owners of a company receive a very good return; yet, it should not be so high that the company faces too great a risk.

Is this same analysis true of rural electric cooperatives? I know many people in the rural electric industry who feel that this is not true. This article will attempt to show the reader that for rural electric cooperatives, the correct debt-to-equity ratio is also one that is "just right."

The Power of Leverage

The use of leverage can be a very profitable and very powerful tool. With many groups, I use a case to demonstrate the power of leverage. A similar case is shown below.

CASE

'An Investment Opportunity'

Jack has researched an investment area where he is very certain that he has devised an investment strategy that can make him a good return and a great deal of money. The following information relates to this potential investment:

Jack believes two things about this investment: (1) he can invest as much money as he wants and still earn his 30% pre-tax profit; and (2) he can borrow as much money as he wants at the fixed borrowing rate of 12%.

Jack believes he has three possible investment strategies:

Approach #1: Invest $50,000 of his own money, borrow nothing from the bank, and let his money compound itself for a period of 15 years.

Approach #2: Invest $50,000 of his own money and borrow $50,000 from his bank to invest. With this approach, not only will Jack let his profits compound themselves for a period of 15 years, but he will also always maintain this one-to-one borrowing ratio he has in this investment. This means that anytime Jack earns a profit on this investment, not only will he leave that profit in the investment, but he will also immediately go to the bank and borrow the same amount of this profit to add to the investment.

Approach #3: Invest $50,000 of his own money and borrow $200,000 from his bank to invest. With this approach, not only will Jack let his profits compound themselves for a period of 15 years, but he will also always maintain this four-to-one borrowing ratio he has in this investment. This means that any time Jack earns a profit on this investment, not only will he leave that profit in the investment, but he will also immediately go to the bank and borrow four times the amount of this profit to add to the investment.

Required: (a) Under Alternative #1, how much will Jack's initial investment of $50,000 grow to after 15 years? (b) Under Alternative #2, how much will Jack's initial investment of $50,000 grow to after 15 years? (c) Under Alternative #3, how much will Jack's initial investment of $50,000 grow to after 15 years?

Solution to the Case

Under alternative #1, Jack's initial $50,000 investment will grow to $646,011 after 15 years. Jack will, of course, owe the bank nothing, meaning that the total investment in this project (or company) will be $646,011.

Under alternative #2, Jack's initial $50,000 investment will grow to $2,489,330 after 15 years. Jack will owe the bank this same amount, meaning that the total investment in this project (or company) will be $4,978,660.

Under alternative #3, Jack's initial $50,000 investment will grow to $77,869,735 after 15 years. That's right, $77,869,735. Jack will owe the bank four times this amount ($311,478,940) meaning that the total investment in this project (or company) will be $389,348,675.

Do you believe those numbers? Although many people I deal with do not, they are correct. Under alternative #1, where no money was borrowed, the risk is very low; therefore, the return is comparatively low. Under alternative #3, the risk is much higher since Jack borrowed--and continues to borrow--four times as much as his own investment. This much higher risk, however, results in a much much higher return.

The point of this case is, of course, to prove the power of leverage. It is also used to prove the axiom that "the higher the risk, the higher the return."

'Return' and Rural Electric Cooperatives

Investors in a publicly-held corporation, such as IBM or Xerox, earn a return on their investment in two ways: (1) yearly dividends, and (2) appreciation in the price of the stock. Investors in a rural electric cooperative (that is, members) also earn a return on their investment in two ways--however, two different ways: (1) capital credits, and (2) lower power rates. What is meant here by "lower power rates" are rates that are lower than would be charged by a for-profit corporation operating in the same environment (i.e., the same plant investment per mile of line, consumers per mile, wholesale power costs, etc.). And a for-profit corporation operating in the same environment would have to charge higher rates than a rural electric cooperative because its owners would have to receive the same return as cooperative members (because of the same risks), yet none of that return would be received through the amounts charged for power.

What is difficult about this concept is that while it is fairly simple to compute the actual rate of return that has been earned by investors in a publicly-held corporation, it is almost impossible to determine the actual rate of return that is being earned by members of a rural electric cooperative. With a publicly-held corporation, the yearly dividends are public knowledge, as is the annual appreciation in the price of the stock. With a rural electric cooperative, the yearly capital credits that are paid are known; however, it is nearly impossible to determine what power rates would have been charged had a for-profit corporation owned this specific cooperative. Still, for this article, it is only necessary to realize that members receive their return from the cooperative in the two ways described above.

What is important, however, is to realize that members can actually receive a return on their investment monies in three ways, not two. Not only can members receive capital credits and lower power rates from their cooperative, but members can also receive a return on any monies that they are not required to invest in the cooperative. For example, if a member (a company) has $100,000 to invest and it is required to invest the entire $100,000 in its cooperative, the member will receive no other return on its investment monies than the capital credits and the lower power rates it receives from the cooperative. If, however, the member is only required to invest $40,000 in the cooperative, it will not only receive its capital credits and its lower power rates, but it will also receive some sort of return on the other $60,000 that it will invest somewhere else.

Leverage and Rural Electric Cooperatives

An argument I often hear is that the use of leverage just isn't the same for a rural electric cooperative. People say, "Borrowing money means interest charges; interest charges result in higher rates for members; and higher rates for members mean a lower return for members."

At first examination, this seems to make sense, but it is not true. This is because of the third return that members can receive--the return on any monies that are not required to be invested in the cooperative.

An example is shown below to demonstrate this point.

Example

The Use of Leverage and Rural Electric Cooperatives

At the beginning of 1993, the AAA Rural Electric Cooperative and the BBB Rural Electric Cooperative are almost identical. Similar information for the two cooperatives is shown below:

The difference between the two cooperatives is the manner in which each has financed its $20,000,000 in assets. AAA has financed its $20 million in assets in the following manner:

Debt: $ 7,000,000 at a weighted average cost of 7.4%(*) Equity: $13,000,000

* The 7.4% was computed by estimating that 50% of the debt was obtained at a 5% annual rate; 36% of the debt was obtained at a 9% annual rate; and 14% of the debt was obtained at a 12% annual rate.

BBB has financed its $20 million in assets in the following manner:

Debt: $16,000,000 at a weighted average cost of 7.4%(*) Equity: $ 4,000,000

* The 7.4% rate was computed in the same manner as shown above for Cooperative AAA.

Given the information above, AAA has determined that it will have to charge its single member $9,118,000 for power in 1993. This was determined in the following manner:

BBB has determined that it will have to charge its single member $9,784,000 for power in 1993. This was determined in the following manner:

If the example stopped here, the argument that the use of leverage isn't the same for a rural electric cooperative would not only seem true, but it would be true. The AAA rural electric cooperative is using less leverage and is charging lower rates. The BBB cooperative, which is using greater leverage, is charging higher rates.

What has been overlooked, however, is that third possible return for members--the return on monies not required to be invested in the cooperative. Two more assumptions, which are related to this non-cooperative return and which are true for both Cooperative AAA and BBB, are shown below:

The owner-member of the AAA rural electric cooperative has the following income flows for 1993:

The owner-member of the BBB rural electric cooperative has the following income flows for 1993:

The example shown above clearly demonstrates that the single owner-member of cooperative BBB is $594,000 better off that the single owner-member of cooperative AAA. This is because the BBB Cooperative is using greater leverage to ensure a higher return for its owner.

There is no trick to the above example, although I hear a wide variety of arguments from people in the industry trying to show me that this concept of leverage is not true for them.

"The member," I hear, "does not have investment monies like you show in your example. He or she usually has to borrow the money that is invested in the cooperative." If the member personally borrows the monies to be invested in the cooperative, the interest rate that he or she is being charged is almost assuredly higher than the rate that would be charged the cooperative itself (the 7.4% weighted average rate shown in the example above). Having the member borrow the money himself would, therefore, result in a lower return for that member.

A rural electric cooperative is no different than any other company. There are only two possible situations where the use of debt by a cooperative will not result in a higher return for its members.

One is if the cooperative's members are able to borrow money at a lower cost than the cooperative. As stated above, this situation will almost never occur. The second situation is if members are not able to earn a return on their non-cooperative investments that is greater than the cost of the cooperative's borrowed funds. This situation would be one where the concept of leverage is not working. It is also a situation that very seldom will occur.

Conclusion

Rural electric cooperatives are no different than any other entity operating in the business environment. The effective use of leverage by the cooperative will result in the highest possible return for its owners |its members~.

Then what is the correct debt-to-equity ratio for a rural electric cooperative? As is true for all business entities, it is one that is "just right"; that is, one that is high enough where the members receive a very good return, yet one that is not so high that the cooperative faces too great a risk.

Tom D. Lewis is an Associate Professor of Accounting at Creighton University in Omaha, Nebraska. Dr. Lewis received his Ph.D. in accounting from the University of Nebraska-Lincoln. He has also received an MBA degree and a BA degree in English, both from the University of Nebraska-Lincoln. He holds both a Certified Public Accountant (CPA) certificate and a Certified Management Accountant (CMA) certificate. Dr. Lewis has been an instructor in the NRECA Management Internship Program (MIP) for over eight years. He has also been an instructor for the NRECA Advanced Financial Workshop for the last three years and has served as an instructor at the annual NRECA Accounting and Finance Conference for the last five years. Dr. Lewis has published numerous accounting articles in such journals as Management Accounting and the Journal of Accounting Education.

Leverage results in great profitability--when it works--because an entity is earning profits without having to invest any of its own money to get that return. The greater an entity's debt-to equity ratio, the greater the use of other people's money to make money. The greater an entity's debt-to-equity ratio, the greater the opportunity for high returns for that entity.

The debt-to-equity ratio is also a measure of risk since the more debt that is used, the greater the risk that the entity might be forced to liquidate and go out of business. This is the case because although equity investors |owners~ will not attempt to put a company out of business, debtors might if the entity fails to make timely interest and/or principal payments.

What should a company's debt-to-equity ratio be? My answer has always been: It should be "just right." By "just right," I mean it should be high enough where the owners of a company receive a very good return; yet, it should not be so high that the company faces too great a risk.

Is this same analysis true of rural electric cooperatives? I know many people in the rural electric industry who feel that this is not true. This article will attempt to show the reader that for rural electric cooperatives, the correct debt-to-equity ratio is also one that is "just right."

The Power of Leverage

The use of leverage can be a very profitable and very powerful tool. With many groups, I use a case to demonstrate the power of leverage. A similar case is shown below.

CASE

'An Investment Opportunity'

Jack has researched an investment area where he is very certain that he has devised an investment strategy that can make him a good return and a great deal of money. The following information relates to this potential investment:

Required Initial Investment As Much As You Like Pre-Tax Return on Investment 30% Interest Rate on Borrowed Funds 12% Jack's Tax Rate 38%

Jack believes two things about this investment: (1) he can invest as much money as he wants and still earn his 30% pre-tax profit; and (2) he can borrow as much money as he wants at the fixed borrowing rate of 12%.

Jack believes he has three possible investment strategies:

Approach #1: Invest $50,000 of his own money, borrow nothing from the bank, and let his money compound itself for a period of 15 years.

Approach #2: Invest $50,000 of his own money and borrow $50,000 from his bank to invest. With this approach, not only will Jack let his profits compound themselves for a period of 15 years, but he will also always maintain this one-to-one borrowing ratio he has in this investment. This means that anytime Jack earns a profit on this investment, not only will he leave that profit in the investment, but he will also immediately go to the bank and borrow the same amount of this profit to add to the investment.

Approach #3: Invest $50,000 of his own money and borrow $200,000 from his bank to invest. With this approach, not only will Jack let his profits compound themselves for a period of 15 years, but he will also always maintain this four-to-one borrowing ratio he has in this investment. This means that any time Jack earns a profit on this investment, not only will he leave that profit in the investment, but he will also immediately go to the bank and borrow four times the amount of this profit to add to the investment.

Required: (a) Under Alternative #1, how much will Jack's initial investment of $50,000 grow to after 15 years? (b) Under Alternative #2, how much will Jack's initial investment of $50,000 grow to after 15 years? (c) Under Alternative #3, how much will Jack's initial investment of $50,000 grow to after 15 years?

Solution to the Case

Under alternative #1, Jack's initial $50,000 investment will grow to $646,011 after 15 years. Jack will, of course, owe the bank nothing, meaning that the total investment in this project (or company) will be $646,011.

Under alternative #2, Jack's initial $50,000 investment will grow to $2,489,330 after 15 years. Jack will owe the bank this same amount, meaning that the total investment in this project (or company) will be $4,978,660.

Under alternative #3, Jack's initial $50,000 investment will grow to $77,869,735 after 15 years. That's right, $77,869,735. Jack will owe the bank four times this amount ($311,478,940) meaning that the total investment in this project (or company) will be $389,348,675.

Do you believe those numbers? Although many people I deal with do not, they are correct. Under alternative #1, where no money was borrowed, the risk is very low; therefore, the return is comparatively low. Under alternative #3, the risk is much higher since Jack borrowed--and continues to borrow--four times as much as his own investment. This much higher risk, however, results in a much much higher return.

The point of this case is, of course, to prove the power of leverage. It is also used to prove the axiom that "the higher the risk, the higher the return."

'Return' and Rural Electric Cooperatives

Investors in a publicly-held corporation, such as IBM or Xerox, earn a return on their investment in two ways: (1) yearly dividends, and (2) appreciation in the price of the stock. Investors in a rural electric cooperative (that is, members) also earn a return on their investment in two ways--however, two different ways: (1) capital credits, and (2) lower power rates. What is meant here by "lower power rates" are rates that are lower than would be charged by a for-profit corporation operating in the same environment (i.e., the same plant investment per mile of line, consumers per mile, wholesale power costs, etc.). And a for-profit corporation operating in the same environment would have to charge higher rates than a rural electric cooperative because its owners would have to receive the same return as cooperative members (because of the same risks), yet none of that return would be received through the amounts charged for power.

What is difficult about this concept is that while it is fairly simple to compute the actual rate of return that has been earned by investors in a publicly-held corporation, it is almost impossible to determine the actual rate of return that is being earned by members of a rural electric cooperative. With a publicly-held corporation, the yearly dividends are public knowledge, as is the annual appreciation in the price of the stock. With a rural electric cooperative, the yearly capital credits that are paid are known; however, it is nearly impossible to determine what power rates would have been charged had a for-profit corporation owned this specific cooperative. Still, for this article, it is only necessary to realize that members receive their return from the cooperative in the two ways described above.

What is important, however, is to realize that members can actually receive a return on their investment monies in three ways, not two. Not only can members receive capital credits and lower power rates from their cooperative, but members can also receive a return on any monies that they are not required to invest in the cooperative. For example, if a member (a company) has $100,000 to invest and it is required to invest the entire $100,000 in its cooperative, the member will receive no other return on its investment monies than the capital credits and the lower power rates it receives from the cooperative. If, however, the member is only required to invest $40,000 in the cooperative, it will not only receive its capital credits and its lower power rates, but it will also receive some sort of return on the other $60,000 that it will invest somewhere else.

Leverage and Rural Electric Cooperatives

An argument I often hear is that the use of leverage just isn't the same for a rural electric cooperative. People say, "Borrowing money means interest charges; interest charges result in higher rates for members; and higher rates for members mean a lower return for members."

At first examination, this seems to make sense, but it is not true. This is because of the third return that members can receive--the return on any monies that are not required to be invested in the cooperative.

An example is shown below to demonstrate this point.

Example

The Use of Leverage and Rural Electric Cooperatives

At the beginning of 1993, the AAA Rural Electric Cooperative and the BBB Rural Electric Cooperative are almost identical. Similar information for the two cooperatives is shown below:

Number of Customers 1(*) Total Assets $20,000,000 Annual Operating Costs, Excluding Interest 8,000,000 Desired Yearly Margins 600,000 * The single member customer assumption is only used for ease of calculations. The end result of this example would be the same regardless of whether there was one customer or 5,000 customers.

The difference between the two cooperatives is the manner in which each has financed its $20,000,000 in assets. AAA has financed its $20 million in assets in the following manner:

Debt: $ 7,000,000 at a weighted average cost of 7.4%(*) Equity: $13,000,000

* The 7.4% was computed by estimating that 50% of the debt was obtained at a 5% annual rate; 36% of the debt was obtained at a 9% annual rate; and 14% of the debt was obtained at a 12% annual rate.

BBB has financed its $20 million in assets in the following manner:

Debt: $16,000,000 at a weighted average cost of 7.4%(*) Equity: $ 4,000,000

* The 7.4% rate was computed in the same manner as shown above for Cooperative AAA.

Given the information above, AAA has determined that it will have to charge its single member $9,118,000 for power in 1993. This was determined in the following manner:

Operating Costs, Excluding Interest $8,000,000 Interest Costs |$7,000,000 x 7.4%~ 518,000 Desired Margins 600,000 Total Desired Revenues $9,118,000

BBB has determined that it will have to charge its single member $9,784,000 for power in 1993. This was determined in the following manner:

Operating Costs, Excluding Interest $8,000,000 Interest Costs |$16,000,000 x 7.4%~ 1,184,000 Desired Margins 600,000 Total Desired Revenues $9,784,000

If the example stopped here, the argument that the use of leverage isn't the same for a rural electric cooperative would not only seem true, but it would be true. The AAA rural electric cooperative is using less leverage and is charging lower rates. The BBB cooperative, which is using greater leverage, is charging higher rates.

What has been overlooked, however, is that third possible return for members--the return on monies not required to be invested in the cooperative. Two more assumptions, which are related to this non-cooperative return and which are true for both Cooperative AAA and BBB, are shown below:

Total Investment Monies For the Member(s) of Each Cooperative $15,000,000 Annual Return on Monies Invested Outside of the Cooperative 14%(*) * This 14% return might be from an investment in a pension fund, an investment in a mutual fund, an investment in the member's own farm, or an investment in the member's own company.

The owner-member of the AAA rural electric cooperative has the following income flows for 1993:

Cost of Power |see above~ $9,118,000 Less: Return on Non-Cooperative Invested Monies: |($15,000,000--$13,000,000(*)) x 14%~ ( 280,000) Net Cost Outflow $8,838,000 * The $13,000,000 is the equity invested in the cooperative.

The owner-member of the BBB rural electric cooperative has the following income flows for 1993:

Cost of Power |see above~ $9,784,000 Less: Return on Non-Cooperative Invested Monies: |($15,000,000--$4,000,000(*)) x 14%~ (1,540,000) Net Cost Outflow $8,244,000 * The $4,000,000 is the equity invested in the cooperative.

The example shown above clearly demonstrates that the single owner-member of cooperative BBB is $594,000 better off that the single owner-member of cooperative AAA. This is because the BBB Cooperative is using greater leverage to ensure a higher return for its owner.

There is no trick to the above example, although I hear a wide variety of arguments from people in the industry trying to show me that this concept of leverage is not true for them.

"The member," I hear, "does not have investment monies like you show in your example. He or she usually has to borrow the money that is invested in the cooperative." If the member personally borrows the monies to be invested in the cooperative, the interest rate that he or she is being charged is almost assuredly higher than the rate that would be charged the cooperative itself (the 7.4% weighted average rate shown in the example above). Having the member borrow the money himself would, therefore, result in a lower return for that member.

A rural electric cooperative is no different than any other company. There are only two possible situations where the use of debt by a cooperative will not result in a higher return for its members.

One is if the cooperative's members are able to borrow money at a lower cost than the cooperative. As stated above, this situation will almost never occur. The second situation is if members are not able to earn a return on their non-cooperative investments that is greater than the cost of the cooperative's borrowed funds. This situation would be one where the concept of leverage is not working. It is also a situation that very seldom will occur.

Conclusion

Rural electric cooperatives are no different than any other entity operating in the business environment. The effective use of leverage by the cooperative will result in the highest possible return for its owners |its members~.

Then what is the correct debt-to-equity ratio for a rural electric cooperative? As is true for all business entities, it is one that is "just right"; that is, one that is high enough where the members receive a very good return, yet one that is not so high that the cooperative faces too great a risk.

Tom D. Lewis is an Associate Professor of Accounting at Creighton University in Omaha, Nebraska. Dr. Lewis received his Ph.D. in accounting from the University of Nebraska-Lincoln. He has also received an MBA degree and a BA degree in English, both from the University of Nebraska-Lincoln. He holds both a Certified Public Accountant (CPA) certificate and a Certified Management Accountant (CMA) certificate. Dr. Lewis has been an instructor in the NRECA Management Internship Program (MIP) for over eight years. He has also been an instructor for the NRECA Advanced Financial Workshop for the last three years and has served as an instructor at the annual NRECA Accounting and Finance Conference for the last five years. Dr. Lewis has published numerous accounting articles in such journals as Management Accounting and the Journal of Accounting Education.

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Author: | Lewis, Tom D. |
---|---|

Publication: | Management Quarterly |

Date: | Jun 22, 1993 |

Words: | 2630 |

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