Why Corporate Profits Are Rising

October 27, 1997

In the long run, strong corporate profits are essential to our economy's well-being. When businesses are not making healthy profits they are in no position to create jobs, increase wages or make new investments. Also, the level of the stock market is ultimately determined by corporate profitability. Thus corporate profits are critical for millions of Americans who own stocks, mutual funds, annuities and other financial assets. If profits were to fall, so would the stock market, thereby reducing the savings people need for retirement, to pay for college education for their children and for other important needs.

  • According to the Commerce Department, the return on nonfinancial corporate assets was 6.7 percent in 1995; from this, corporations paid 2.2 percent in taxes, leaving an aftertax rate of return of just 4.5 percent (see chart).
  • As modest as this was, however, it represented a substantial rise from recent years -- it was two and a quarter times higher than the 2 percent aftertax return U.S. corporations earned in 1980, and more than one-third higher than the 3.3 percent rate in 1990.
  • But the rate of return in 1995 was still well below that of the 1960s, when corporations routinely earned between 5 percent and 7 percent aftertax.

Much of the recent rise in corporate profits stems from lower interest costs. The growth of corporate debt has been quite restrained during this economic expansion compared to those in the past. Last year debt grew just 5.1 percent. At a similar stage in the previous economic expansion in 1988, debt grew 11.6 percent. Combined with lower interest rates, this means that companies have been able to reduce their interest payments from $147.5 billion in 1990 to $88.5 billion in 1996.

A major reason why corporations are borrowing less is because they have been able to keep inventories low. Computers and dependable overnight delivery services have allowed companies to free up capital that would otherwise be used to maintain stocks and operate more efficiently. The inventory/sales ratio in manufacturing has fallen from 1.95 in 1982 to just 1.34 currently, a record low level. Better inventory management not only increases corporate profits, but greatly reduces economic volatility, thereby reducing the chances of a recession.

Lower levels of corporate debt, combined with a lower federal deficit, means that billions of dollars in interest payments that would otherwise be reinvested in Treasury securities and corporate bonds instead have gone into the stock market. Thus we have a virtuous cycle in which lower debt and lower interest rates increase corporate profits and investments in stocks, driving the market higher. There is no reason why the trend cannot continue for some time to come.

 

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