Debt and Firm Vulnerability
by Jack Glen of the International Finance Corporation
Abstract: Debt introduces firm vulnerability to insolvency as cash flow must be available to make interest payments. This paper reviews the empirical evidence on a sample of more than 6,000 real sector firms in 41 countries and their ability to service debt, as measured by the ratio of cash flow to interest expense, for the period 1994-01. Firm specific, sector-specific and macroeconomic factors all influence this ratio. The analysis specifically shows a strong link between macroeconomic conditions and ability to service debt; as GDP growth slows, cash flow becomes constrained, more than offsetting any impact from lower interest rates. This business cycle effect would account for much of the distress observed in the East Asian economies following the 1997 crisis. It also provides a basis for estimating the impact of a business cycle or macroeconomic shocks on loan or bond portfolios.