Investment analysts use a variety of metrics to summarize a company’s financial performance. One of those is the interest coverage ratio. The interest coverage ratio is how many times a company can pay the interest on its total debt at a given income level.
As an example, let’s say a new college graduate making a $50,000 salary with $80,000 in college loans at 4% interest and a $10,000 car loan at 5%. That’s a $3200 annual interest payment for the school loan (.04×80,000) and $500 (.05×10,000) for the car loan. The interest coverage ratio is:
50,000/(3200+500) = 13
13 is a pretty high ratio. It indicates that the borrower can handle the loan payments and might be able to take on more debt, if necessary. Issues, however, arise when the ratio is 3, or 2, or, worse, less than 1. An interest coverage ratio of 1 or less means that using all the income for a company couldn’t cover the short-term interest payment. Imagine that — a debt so large that your entire salary only covers the minimum payment… which means either borrowing more money to pay interest on the old debt, or finding some other source of funds, like working another job. Often, this is a sign of impending bankruptcy.
In the midst of all this talk about our (yours and mine, grasshopper) national debt, there’s been very little done to give it perspective — how much is too much? Bigger than a breadbox? 100% of GDP? One point twenty-one jiggawatts (spelling error intentional)?
Measuring debt to GDP is what we usually see in the news, but it’s useless from an accounting perspective. It doesn’t say anything about the ability to pay. Also, consider that debt is an actual accounting figure and can be measured — to the dollar — but GDP is a loose estimate of a nation’s total output that double counts some things and misses others. I’d suggest a better measure is one that compares debt to another figure that can also be measured to the dollar. Measuring it against government revenue is one option — and that will give us an interest coverage ratio.
In 2008, the average debt was $9,468,250,000,000. $9.4 trillion. It cost the US $412,000,000,000 – $412 billion – in interest payments to service that debt.
That comes out to about a 4.4% interest rate.
In 2008, tax revenues were $2,500,000,000,000. That is, 2.5 trillion dollars. Keep in mind that tax revenues are pretty much the top line revenue that our government makes. If this were a company, we’d subtract out all the expenses to get this revenue — the cost of the IRS, the cost of all the computers that presumably receive all your TurboTax transmissions, the cost of 1099 compliance and follow-up, etc.
But I’m bored of writing this and want to go to have an IPA, so screw digging that stuff up and let’s just play with the top tax revenue.
With these numbers, the interest coverage ratio for 2008 is 6.068.
This means that in 2008 we could make the minimum payment on our federal credit card six times over – that’s interest only. It means 16% of 2008 tax revenue had to go to interest payments, leaving 84% of revenue for other programs. Education, highways, farm subsidies, etc.
Now, the average debt for fiscal year 2011 was $14,152,974,847,024.¹
Interest expense for fiscal year 2011 was $434,131,324,866. The implied interest rate is 3%.
Estimated federal tax revenue for FY 2011 will be $2,173,700,000,000.²
The interest coverage ratio for 2011 is thus 5. Getting a bit worse, of course, since the debt is going up.
In business, we do silly things called “scenario analyses,” which essentially examine the numbers to see what would cause the universe to explode and babies to cry. I’m curious what would have to change to cause the ratio to drop to 1 — where all tax revenues are needed just to pay the interest on the debt?
Assume we manage to keep the interest rate low at 3% — which is possible, since we (the US) have been buying up our (the US) debt for a while, which keeps the rate low by making it seem like there are buyers. And assume, as I do, we stay in a recession for a few years, which means tax revenues flatline, like they have the last few years. At what point do interest expenses equal tax revenue?
$15 trillion 4.7
$20 trillion 3.5
$30 trillion 2.4
$40 trillion 1.8
$70 trillion 1
So, half of revenue will be going towards interest payments at a debt of around $35 trillion. All of it goes to interest payments when the debt hits $70 trillion, at a 3% interest rate. That’s like everything you earn going towards the minimum payment on your credit card.
The government forecasts the debt to increase by $5 trillion or so in the next five years³, which would top us out at a 3.5 ratio at 3%. I find the government continually underestimates its ability to waste money, but if we believe it, then at the peak of our debt, we’ll be spending 30% of our tax revenue on interest payments — and more if we actually want to pay it down. A person earning $50,000 would be spending $15,000 on the minimum payment on their credit card. That’s the current price of borrowing and spending money in the past.
But what if the US cannot continue to borrow its own debt, and the interest rate goes up? The rate was 4% in 2008. If it goes back to that, the ratio hits 2 at $27 trillion – half of all revenue going to the minimum payment. It hits 1 at $54 trillion.
At 5%, we hit a ratio of 2 at $21 trillion. At 6%, it hits 2 at $18 trillion. A $20 trillion debt at 6% means we’d be spending over half of all tax revenues on the interest of the debt.
Where do we get the money to keep all our programs going when half of our revenue is going to interest payments? We’d have to borrow it. And borrowing, of course, increases the interest payment. That’s the spiral towards bankruptcy that so many people don’t think can happen. It can happen.
For now, that means the US has every incentive to keep the interest rate down for the next 5-10 years, otherwise it will teeter over the edge into inevitable bankruptcy. So far, they’re successful. As long as people are out there buying our debt at low rates, the rates remain low. Luckily, no one seems to care that the US government has been the largest buyer of US government securities over the last few years.
One last happy note: what’s even more fun is calculating the interest coverage ratio with unfunded obligations included. When we do that — we’re already bankrupt. There’s no conceivable way we can pay unfunded obligations as they stand. We’ll play with that next.
¹ The US Government TreasuryDirect: http://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm
² IRS Estimate: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=203
Also http://www.usgovernmentrevenue.com/fed_revenue_2011USbn (which probably gets its figures from the IRS)