RDP 9308: Balance Sheet Restructuring and Investment 4. Implications for Investment

The recent behaviour of corporate balance sheets and investment has been related through two channels. First, firms in financial distress have been effectively constrained by the state of their balance sheets from expanding investment. Second, the shift in the relative cost of external funds has encouraged firms with healthy balance sheets to reduce leverage and investment – firms perceived that the return to financial restructuring exceeded that of physical investment. These factors exacerbated the normal effects of a slowdown in the economy on investment. Consequently, the fall in investment has been historically large despite the fact that other factors thought to influence investment – returns to capital, Tobins's ‘q’ and cash flows – have not behaved atypically.

The extent of the deviation from past behaviour can be illustrated using a simple aggregate investment equation containing a measure of Tobin's ‘q’ and cash flow as explanatory variables. This was estimated up to 1989. Graph 14 plots the out-of-sample predictions of the equation. Although the model predicted that investment growth would slow considerably over the period, the actual fall in investment was much larger.[19] This is consistent with the hypothesis that firms have responded to balance sheet constraints and shifts in the cost of funding at the expense of investment.

Graph 14: Business Fixed Investment (Actual v Predicted Change)

In the near term, some focus on financial restructuring may remain. A few firms are still highly geared and have problems to work through. For many firms, however, the process of restructuring appears to have advanced a long way (though the extent to which it has been completed is conjectural – theory does not provide a clear yardstick to judge empirically the optimal capital structure). Overall, the reduction in leverage and improved interest cover suggest that the imperative for most firms to reduce debt further should now be considerably reduced, and that many should be in a better position to expand investment when other factors are favourable.

Some of these factors are falling into place. Measures of the profit share are relatively strong for this point in the cycle. A common feature of the falls in investment in 1974/75 and 1982/83 was that there was a marked shift in factor shares away from profits due to rapid increases in real wages. The reduction in real wages during the 1980s helped to raise the profit share over the course of the decade. Despite some fall in profits in the most recent downturn, the profit share remained relatively high (Graph 1). Trends in various measures of the average rate of return on the existing capital stock show a similar pattern (Graph 1). While each measure of the return to capital has declined from the pre-recession peaks, they are well above the trough in 1982/83 and above the levels of the 1970s.

More forward-looking measures, incorporating information from share prices, point to expectations of further strong gains in profits. Graph 15 plots Tobin's ‘q’ – the ratio of the market value of capital relative to its replacement cost. When the market value exceeds the costs of replacing capital – i.e. when the ratio is greater than one – firms have an incentive to acquire new capital. While the measure does not explain short-run movements in investment very well, the broad trends do seem to be related. This is not surprising since share prices and investment should both be driven by the same factors. For example, when share prices were weak in the mid to late 1970s so too was investment and conversely for the second half of the 1980s. On this measure, incentives to invest are relatively high compared with earlier periods.

Graph 15: Tobin's ‘q’ Ratio

Cash flows have also improved strongly (Graph 16). The theory outlined earlier suggested that there would be a positive correlation between investment and cash flows and that cash flows would be a major source of finance for investment. The results in equation 1 show that there is a significant relationship between cash flows and investment. Mills, Morling and Tease (1993), using a database of major Australian companies, find similar evidence. Cash flows are also clearly the most important source of finance (Graph 17, Table 1). Graph 17 plots the sources of funds as a ratio to investment using the STATEX sample. Total funds raised by the corporate sector are typically much larger than required to finance new fixed investment – they are also used, for example, to pay dividends, acquire financial assets and to cover depreciation. Cash flows have traditionally been the largest source of funds and generally are well above fixed capital expenditures. New debt raisings have been the next most important source followed by new equity raisings.

Graph 16: Cash Flow over the Cycle
Graph 17: Funding Sources as a Ratio to Investment

Cash flows fell as the economy entered recession but have since recovered. The recovery in cash flows is much the same as in the 1982/83 episode and somewhat stronger than 1974/75 (Graph 16). Investment has responded differently to cash flows this cycle, however. One reason for this, apart from balance sheet restructuring, may be that the pick-up in cash flows did not reflect a substantial rise in corporate sales and revenue. Hence, it did not signal a rise in demand that would encourage investment. Rather, the improvement has come from cost cutting and productivity gains, and from the reduction in net interest payments stemming from reduced corporate gearing and lower nominal interest rates. The sluggishness in corporate revenues reflects the fact that output growth has been relatively weak since the recovery from the trough in June 1991. This weak output growth has meant that firms are operating at well below capacity. While it is difficult to measure the degree of spare capacity, available measures suggest that firms are operating with excess capacity at around the levels of the 1982/83 recession (Graph 18).[20] An acceleration of growth and reduction of excess capacity, or at least a higher level of confidence about future growth prospects will be important for the recovery in investment.

Graph 18: Capacity Utilisation


We use an investment equation based on McKibbin and Siegloff (1987) in which the percentage change in real business fixed investment is a function of the percentage change in Tobins ‘q’ and the percentage change in real business cash flows. The model is estimated by OLS using annual data over the period 1961/62 to 1988/89. Independent variables are lagged to allow for the timing difference between investment decisions and recorded investment expenditures. The model is:

Adjusted R Square = 0.35 DW=2.36

t-statistics in brackets

This simple equation is not a comprehensive investment model. Rather it should be interpreted as a simple baseline against which to compare current investment behaviour.


The capacity utilisation data are taken from the ACCI/Westpac survey. [20]