Fact checked by Ariel Courage
Reviewed by Erika Rasure

A recession is a significant, persistent, and widespread contraction in economic activity. Since the Great Depression, the United States has suffered 14 official recessions. Here, we break down each one.

Key Takeaways

• A recession is an economic downturn that typically lasts for more than a few months.
• Recessions in the United States have become shorter and less frequent in recent decades.
• The COVID-19 recession was the shortest on record, while the Great Recession of 2007-2009 was the deepest since the downturn in 1937-1938.

What’s a Recession?

Recessions are sometimes defined as two consecutive quarters of decline in real gross domestic product (GDP), which measures the combined value of all the goods and services produced in an economy.

In the U.S., the National Bureau of Economic Research (NBER) dates recessions based on indicators including GDP, payroll employment, personal income and spending, industrial production, and retail sales.

Important

Recessions have grown increasingly infrequent over the past four decades.

Surveying Past U.S. Recessions

Let’s take a look at all of the official U.S. recessions since the Great Depression, focusing on common measurements of their severity as well as causes.

• Duration: How long did the recession last, according to NBER?
• GDP Decline: How much did economic activity contract from its prior peak?
• Peak Unemployment Rate: What was the maximum proportion of the workforce left jobless?
• Reasons and Causes: What unique circumstances contributed to the recession?

The Own Goal Recession: May 1937–June 1938

• Duration: 13 months
• GDP Decline: 10%
• Peak Unemployment Rate: 20%
• Reasons and Causes: Expansionary monetary and fiscal policies had secured a recovery from the Great Depression after 1933, albeit an uneven and incomplete one. In 1936-1937 policymakers changed course, more preoccupied with cutting budget deficits and heading off inflation than with the dangers of a depressive relapse. Following a tax increase in 1935 and Social Security payroll deductions starting in 1937, the budget deficit shrank from 5.4% of GDP in 1936 to 0.1% of GDP by 1938. Meanwhile, the Federal Reserve in 1936 doubled the reserve requirement ratios for banks, thus curbing lending with the stated aim of preventing “an injurious credit expansion.” Perhaps most damaging of all, the U.S. Treasury began the same year to sterilize gold inflows, ending brisk money supply growth that had supported the expansion. Industrial production began falling in September. It would decline 32% in the course of the recession. The stock market crashed in October. The recession ended after policymakers rolled back the increase in reserve requirements and gold sterilization as well as fiscal austerity.

The V-Day Recession: February 1945–October 1945

• Duration: Eight months
• GDP Decline: 10.9%
• Peak Unemployment Rate: 3.8%
• Reasons and Causes: The 1945 recession reflected massive cuts in U.S. government spending and employment toward the end and immediately after World War II. Federal spending fell 40% in 1946 and 38% in 1947 while the private sector’s output grew rapidly. The severity of the downturn remains open to question because much of the eliminated spending represented wartime production that did not serve to increase living standards. The elimination of price controls in 1946 artificially depressed output as adjusted for inflation, while the unemployment rate remained low in part because women left the workforce in large numbers.

The Post-War Brakes Tap Recession: November 1948–October 1949

• Duration: 11 months
• GDP Decline: 1.7%
• Peak Unemployment Rate: 7.9%
• Reasons and Causes: The first phase of the post-war boom was in some ways comparable to the economic recovery from the COVID-19 pandemic. Amid a backlog of consumer demand suppressed during the war and a shortage of production capacity, the collapse of wartime price controls fueled an abrupt surge of inflation by mid-1946. The annualized inflation rate rose from 3.3% in June 1946 to 11.6% two months later and 19% at its peak in April 1947. Policymakers only responded in the second half of 1947, and when they did their efforts to tighten credit ultimately led to a relatively mild recession as consumers and producers retrenched.

The Post-Korean War Recession: July 1953–May 1954

• Duration: 10 months
• GDP Decline: 2.7%
• Peak Unemployment Rate: 5.9%
• Reasons and Causes: The wind-down of the Korean War caused government spending to decline dramatically, lowering the federal budget deficit from 1.7% of GDP in fiscal 1953 to 0.3% a year later. Meanwhile, the Federal Reserve tightened monetary policy in 1953.

The Investment Bust Recession: August 1957–April 1958

• Duration: Eight months
• GDP Decline: 3.7%
• Peak Unemployment Rate: 7.4%
• Reasons and Causes: The end of the Korean War unleashed a global investment boom marked by a surge in exports of U.S. capital goods. The Fed responded by tightening monetary policy as the inflation rate rose from 0.4% in March 1956 to 3.7% a year later. Fiscal policy focused on limiting budget deficits produced a surplus of 0.7% of GDP in 1957. The 1957 Asian Flu pandemic killed 70,000 to 100,000 Americans in 1957, and industrial production slumped late that year and early in 1958. The dramatic drop in domestic demand and evolving consumer expectations led to the failure of the Ford Edsel, the beginning of the end for Detroit’s auto industry dominance. The sharp worldwide recession contributed to a foreign trade deficit. The recession ended after policymakers eased fiscal and monetary constraints on growth.

The ‘Rolling Adjustment’ Recession: April 1960–February 1961

• Duration: 10 months
• GDP Decline: 1.6%
• Peak Unemployment Rate: 6.9%
• Reasons and Causes: This relatively mild recession was named for the so-called “rolling adjustment” in U.S. industrial sectors tied to consumers’ diminished demand for domestic autos amid growing competition from inexpensive imports. Like most other recessions, it was preceded by higher interest rates, with the Fed increasing the federal funds rate from 1.75% in mid-1958 to 4% by the end of 1959. Fiscal policy also tightened at the end of President Dwight Eisenhower’s second term, from a deficit of 2.6% of GDP in 1959 to a surplus of 0.1% a year later.

The Guns and Butter Recession: December 1969–November 1970

• Duration: 11 months
• GDP Decline: 0.6%
• Peak Unemployment Rate: 5.9%
• Reasons and Causes: Military spending increased in the late 1960s amid growing U.S. involvement in the Vietnam War and alongside high expenditures on domestic policy initiatives. As a result, the federal budget deficit rose from 1.1% of GDP in 1967 to 2.9% in 1968, while inflation increased from 3.1% in 1967 to 4.3% a year later and 5.3% by 1970. The Federal Reserve increased the federal funds rate from 5% in March 1968 to more than 9% by August 1969. By early 1971, the Fed had lowered the federal funds rate back below 4%, aiding the recovery.

The Oil Embargo Recession: November 1973–March 1975

• Duration: 16 months
• GDP decline: 3%
• Peak Unemployment Rate: 8.6%
• Reasons and causes: This long, deep recession began following the start of the Arab Oil Embargo, which would quadruple crude prices. That tipped the balance for an economy struggling with the devaluation of the dollar amid high U.S. trade and budget deficits and slipping domestic crude output. The collapse of the Bretton Woods Agreement fixing currency exchange rates contributed to a rise in U.S. inflation from 2.4% in August 1972 to 7.4% a year later, causing the Fed to double the federal funds rate to 10% between late 1972 and mid-1973. After increasing the federal funds rate to 13% in the first half of 1974, the Fed cut it to 5.25% in under a year. Inflation and unemployment remained elevated after the recession ended, ushering in stagflation. Unemployment reached 9% in May of 1975, after the declared end of the recession.

The Iran and Volcker Recession, Part 1: January 1980–July 1980

• Duration: Six months
• GDP Decline: 2.2%
• Peak Unemployment Rate: 7.8%
• Reasons and Causes: Accommodative monetary policy aimed at alleviating rising unemployment pushed U.S. inflation to 7% by early 1979, just before the Iranian Revolution caused oil prices to double. The Federal Reserve was already raising rates when Paul Volcker was named Fed chair in August 1979, and the rate went from 10.5% at the time of his appointment to 17.5% by April 1980. This short recession formally ended as the Fed dropped the fed funds rate back down to 9.5% by August of 1980, but inflation stayed high and the Volcker Fed wasn’t done.

Part 2 of Double-Dip Recession: July 1981–November 1982

• Duration: 16 months
• GDP Decline: 2.9%
• Peak Unemployment Rate: 10.8%
• Reasons and Causes: By the fourth quarter of 1980 inflation was up to 11.1%, prompting the Federal Reserve to raise the fed funds rate to 19% by July 1981. As the downturn worsened and joblessness climbed, Volcker resisted repeated demands in Congress to change course. By October 1982 inflation had declined to 5%, while unemployment would remain above 10% until mid-1983. Most economists today accept Volcker’s arguments at the time that failure to control inflation and restore the Fed’s credibility would have led to continued economic underperformance.

The Gulf War Recession: July 1990–March 1991

• Duration: Eight months
• GDP Decline: 1.5%
• Peak Unemployment Rate: 6.8%
• Reasons and Causes: This relatively mild recession began a month before Iraq invaded Kuwait, and the resulting oil price shock may have contributed to a frustratingly lackluster recovery. The Fed had raised the federal funds rate from 6.5% in February 1988 to 9.75% in May 1989 in an effort to contain inflation, which rose from 2.2% in 1986 to 3.9% for 1990.

The Dot-Bomb Recession: March 2001–November 2001

• Duration: Eight months
• GDP Decline: 0.3%
• Peak Unemployment Rate: 5.5%
• Reasons and Causes: The collapse of the dot-com bubble contributed to one of the mildest recessions on record following what was then the longest economic expansion in U.S. history. The Fed raised the fed funds rate from 4.75% in early 1999 to 6.5% by July 2000. The September 11 attacks and the associated economic disruptions may have hastened the recession’s end by encouraging the Fed to keep cutting the fed funds rate. The benchmark rate reached a low of 1% by mid-2003.

The Great Recession: December 2007–June 2009

• Duration: Eighteen months
• GDP Decline: 4.3%
• Peak Unemployment Rate: 9.5%
• Reasons and Causes: The nationwide downturn in U.S. housing prices triggered a global financial crisis, a bear market in stocks that had the S&P 500 down 57% at the lows, and the worst economic downturn since the recession of 1937-38. Global investment flows into the U.S. had kept market rates low, likely encouraging unscrupulous mortgage underwriting and mortgage-backed securities marketing practices. Oil prices spiked to record highs by mid-2008 and then crashed, depressing the U.S. oil industry. Dropping oil and commodity prices led to deflation and strained the U.S. economy.

The COVID-19 Recession: February 2020–April 2020

• Duration: Two months
• Peak Unemployment Rate: 14.7%
• Reasons and Causes: The COVID-19 pandemic spread to the U.S. in early 2020, and the resulting travel and work restrictions caused employment to plummet, triggering an unusually short but sharp recession. The unemployment rate climbed from 3.5% in February 2020 to 14.7% in April 2020 but was back below 4% by the end of 2021, capped by $5 trillion in pandemic relief spending. In addition, quantitative easing by the Federal Reserve expanded its balance sheet from $4.1 trillion in February 2020 to nearly $9 trillion by the end of 2021, complementing a federal funds rate that remained near zero until March 2022.

What Is the Average Length of a Recession?

The U.S. has experienced 34 recessions since 1857 according to the NBER, varying in length from two months (February to April 2020) to more than five years (October 1873 to March 1879). The average recession has lasted 17 months, while the six recessions since 1980 have lasted less than 10 months on average.

Which Stocks Tend Fare Better During a Recession?

Companies in the consumer staples, health care, and utilities sectors, which see relatively small fluctuations in demand for economic reasons, tend to fare best during recessions, and their stocks have outperformed during past downturns as a result.

Do Recessions Always Coincide with Bear Markets?

A bear market is commonly defined as a sustained drop of 20% or more from a market peak. Of the 25 bear markets since 1928, 14 have overlapped with recessions.

The Bottom Line

As the history of recessions over the past century or so suggests, they’re almost always preceded by monetary policy tightening in the form of rising interest rates. Fiscal contractions, whether they involve lower government spending, higher taxes, or both, have also played a role.

This is not to automatically deprecate such policies when they lead to a recession. In some cases, as during the 1970s, the long-run alternative to immediate economic pain may be even less palatable. In others, as with the end of World War II and the Korean War, there may be no easy way or no will to find immediate alternatives to high military spending.

That doesn’t change the fact that most modern recessions have occurred in response to some combination of rising interest rates, lower budget deficits, and higher energy prices.

Fact checked by Patrice Williams
Reviewed by David Kindness

Working capital represents a company’s ability to pay its current liabilities with its current assets. This figure gives investors an indication of the company’s short-term financial health, its capacity to clear its debts within a year, and its operational efficiency.

Working Capital Formula

Subtract a company’s current liabilities from its current assets.

Key Takeaways

• Working capital is the amount of available capital that a company can readily use for day-to-day operations.
• It represents a company’s liquidity, operational efficiency, and short-term financial health.
• Subtract a company’s current liabilities from its current assets to calculate working capital.
• A positive amount of working capital means that a company can meet its short-term liabilities and continue its day-to-day operations.
• Current assets divided by current liabilities, called the current ratio, is a liquidity ratio often used to gauge short-term financial well-being. It’s also known as the working capital ratio.

Components of Working Capital

Current Assets

Current assets are assets that a company can easily turn into cash within one year or one business cycle, whichever is less. They don’t include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.

Examples of current assets include:

• Checking and savings accounts
• Highly liquid marketable securities such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs)
• Money market accounts
• Cash and cash equivalents
• Accounts receivable
• Inventory and other shorter-term prepaid expenses
• Current assets of discontinued operations and interest payable

Current Liabilities

Current liabilities are all the debts and expenses that the company expects to pay within a year or one business cycle, whichever is less. They typically include:

• Normal costs of running the business, such as rent, utilities, materials, and supplies
• Interest or principal payments on debt
• Accounts payable
• Accrued liabilities
• Accrued income taxes
• Dividends payable
• Capital leases that are due within a year
• Long-term debt that’s coming due

How to Calculate Working Capital

Working capital is calculated by subtracting current liabilities from current assets. Calculating the metric known as the current ratio can also be useful. The current ratio, also known as the working capital ratio, provides a quick view of a company’s financial health.

You can calculate the current ratio by taking current assets and dividing that figure by current liabilities. A ratio above one means that current assets exceed liabilities. Generally, the higher the ratio, the better an indicator of a company’s ability to pay short-term liabilities.

But a very high current ratio means a large amount of available current assets and may indicate that a company isn’t utilizing its excess cash as effectively as it could to generate growth.

Working Capital Example: Coca-Cola

The Coca-Cola Co. (KO) had current assets valued at $36.54 billion for the fiscal year ending Dec. 31, 2017. They included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.

Coca-Cola also registered current liabilities of $27.19 billion for that fiscal year. The company’s current liabilities consisted of accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.

Coca-Cola’s current ratio was 1.34 based on this information:

$36.54 billion ÷ $27.19 billion = 1.34

Does Working Capital Change?

The amount of working capital does change over time because a company’s current liabilities and current assets are based on a rolling 12-month period, and they change over time.

Working Capital Can Change Daily

The exact working capital figure can change every day depending on the nature of a company’s debt. What was once a long-term liability, such as a 10-year loan, becomes a current liability in the ninth year, when the repayment deadline is less than a year away.

What was once a long-term asset, such as real estate or equipment, can suddenly become a current asset when a buyer is lined up.

Current Assets Can Be Written Off

Working capital can’t be depreciated as a current asset the way long-term, fixed assets are. Certain working capital such as inventory can lose value or even be written off, but that isn’t recorded as depreciation.

Note

Working capital can only be expensed immediately as one-time costs to match the revenue they help generate in the period.

Assets Can Be Devalued

Working capital can’t lose its value to depreciation over time, but it may be devalued when some assets have to be marked to market. This can happen when an asset’s price is below its original cost and others aren’t salvageable. Two common examples involve inventory and accounts receivable.

Inventory obsolescence can be a real issue in operations. The market for the inventory has priced it lower than the inventory’s initial purchase value as recorded in a company’s books. A company marks the inventory down to reflect current market conditions and uses the lower of cost or market method, resulting in a loss of value in working capital.

Accounts Receivable May Be Written Off

Some accounts receivable may become uncollectible at some point and have to be totally written off, representing another loss of value in working capital. It may take longer-term funds or assets to replenish the current asset shortfall because such losses in current assets reduce working capital below its desired level. This is a costly way to finance additional working capital.

Unearned revenue from payments received before the product is provided will also reduce working capital. This revenue is considered a liability until the products are shipped to the client.

Important

Working capital should be assessed periodically over time to ensure that no devaluation occurs and that there’s enough left to fund continuous operations.

What Does the Current Ratio Indicate?

A healthy business has working capital and the ability to pay its short-term bills. A current ratio of more than one indicates that a company has enough current assets to cover bills that are coming due within a year. The higher the ratio, the greater a company’s short-term liquidity and its ability to pay its short-term liabilities and debt commitments.

A higher ratio also means that the company can continue to fund its day-to-day operations. The more working capital a company has, the less likely it is to take on debt to fund the growth of its business.

A company with a ratio of less than one is considered risky by investors and creditors because it demonstrates that the company might not be able to cover its debts if needed. A current ratio of less than one is known as negative working capital. 

We can see in the chart below that Coca-Cola’s working capital, as shown by the current ratio, has improved steadily over a few years. This indicates improving short-term financial health.

Special Considerations

A more stringent liquidity ratio is the quick ratio. This measures the proportion of short-term liquidity compared to current liabilities. The difference between this and the current ratio is in the numerator where the asset side includes only cash, marketable securities, and receivables. The quick ratio excludes inventory because it can be more difficult to turn into cash on a short-term basis.

What Is Working Capital?

Working capital is the amount of money that a company can quickly access to pay bills due within a year and to use for its day-to-day operations. It can represent the short-term financial health of a company.

How Does a Company Calculate Working Capital?

You can calculate working capital by taking the company’s total amount of current assets and subtracting its total amount of current liabilities from that figure. The result is the amount of working capital that the company has at that time. Working capital amounts can change.

What Does Working Capital Indicate?

Working capital is the amount of current assets left over after subtracting current liabilities. It’s what can quickly be converted to cash to pay short-term debts. Working capital can be a barometer for a company’s short-term liquidity. A positive amount of working capital indicates good short-term health. A negative amount indicates that a company may face liquidity challenges and may have to incur debt to pay its bills.

The Bottom Line

Working capital is the difference between a company’s current assets and current liabilities. The challenge here is determining the proper category for the vast array of assets and liabilities on a corporate balance sheet to decipher the overall health of a company and its ability to meet its short-term commitments.

Fact checked by Betsy Petrick

Banks may have more advertising dollars to spend on promoting personal loans, but the loans they offer are not necessarily better than those offered by credit unions. Many credit unions offer more favorable borrowing terms like lower interest rates and fewer fees. However, you do have to qualify for credit union membership in order to apply.

Key Takeaways

• You have options when it comes to taking out a personal loan—you’ll find them from banks, credit unions, and online lenders.
• Banks offer more branches and in-person customer service, while credit unions have fewer locations and are limited to specific regions.
• Credit unions typically require you to be a member in order to get a personal loan.
• Credit unions may offer lower rates and fees, while banks may offer more convenience.

Banks vs. Credit Union Loans

A bank is a financial institution authorized to offer services and accounts like checking and savings or loans like personal loans, auto loans, and mortgages. Banks operate in order to generate a profit and they are regulated by the federal government.

Although credit unions operate similarly to banks and have many of the same credit products and financial accounts, they do not operate to generate revenue. Credit unions are usually established as a network of nonprofit financial institutions that operate within a geographic region or a community. Because of this, they usually have membership requirements and might charge a small fee to join.

In order to get a personal loan from a bank, one simply has to submit an application. The bank will review the application, pull your credit score, and issue a decision. Getting a personal loan from a credit union follows the same process, but the credit union will also usually check that you’re a member. If you aren’t and you meet membership requirements, you can apply, pay the membership dues, and become a member. The process may only take a few minutes.

Tip

Many credit unions extend membership eligibility to anyone who is a member of an affiliate group, and you can typically join those affiliate groups for a small fee to gain access to credit unions. One such organization is the American Consumer Council, which partners with many credit unions nationwide. Check with your local credit union to see which organizations it partners with.

Personal Loans From Banks

Almost all major banks offer a variety of loans like mortgages, auto loans, student loans, and personal loans. If you already have a home bank, you may have received pre-approval offers for loans for which you’re already qualified.

Pros of Personal Loans From Banks

• Convenient to work with your current bank: If you already have a bank that you have a checking or savings account with, you might be more comfortable working with them. After all, you already have a relationship with the bank and know your way around the website and app.
• Wide access to a number of locations: Banks are known for their established brick-and-mortar branches, in case you need to visit a location in person.
• More customer service availability: The larger the bank, the better the chances it has customer service available via phone, web chat, or mobile app for more hours per week. Some banks operate 24/7 customer service lines.

Cons of Personal Loans From Banks

• More challenging qualification requirements: Lending money is risky for any type of financial institution. Since banks lend larger sums of money, it’s in their interest to ensure the debt will be repaid. To manage that risk, banks may require borrowers to have a higher credit score.
• Higher interest rates and fees: Again, banks try to manage risk when it comes to lending, and they usually have higher interest rates and more fees compared to credit unions, especially if you don’t have other banking products (like checking or savings accounts) with the bank.

Best Banks for Personal Loans

Lender	Best For	Loan Amounts	Repayment Terms	APRs
Citibank	Overall	$2,000 to $30,000	12 to 60 months	11.49% to 20.49%
Discover	Debt consolidation	$2,500 to $40,000	36 to 84 months	7.99% to 24.99%
Santander	Fast funding	$5,000 to $50,000	36 to 84 months	7.99% to 24.99%
Wells Fargo	Large loan amounts	$3,000 to $100,000	12 to 84 months	6.99% to 24.49%
U.S. Bank	Repayment terms	$1,000 to $50,000	12 to 84 months	7.99% to 24.99%
American Express	Amex cardholders	$3,500 to $40,000	12 to 60 months	6.90% to 19.97%

Learn more about the best banks for personal loans to find the right lender for your financial situation.

Personal Loans From Credit Unions

Credit unions have many of the same banking products as banks, but they don’t operate for profit. Instead, the credit union is made up of members who pay small fees to access financial services.

Pros of Personal Loans From Credit Unions

• Less rigorous lending requirements: Credit unions often pride themselves on working with all members, including those with poor or average credit. If you don’t qualify for a loan at a bank, you might be able to get one through a credit union.
• Lower interest rates and fees: Because credit unions operate to assist their members, they can offer competitive interest rates and might not charge fees like those imposed by big banks (like origination fees). Even though differences may be minor percentage points, this can add up to hundreds or thousands of dollars in savings for a personal loan.

Cons of Personal Loans From Credit Unions

• Membership is usually required: Unlike a bank where anyone can apply for a loan, you usually must be a credit union member before opening an account with one. You usually can join the credit union and apply for a personal loan at the same time, but you’ll have to submit an application and possibly pay a fee.
• It might take longer to get the funds: Large banks can quickly transfer the personal loan funds to you, but credit unions might take longer to issue them. Credit unions also might place more restrictive limits on how much you can borrow, although most people probably won’t run into the upper limit. But if you need a very large sum of money fast, this could be a deal breaker.
• Not as many credit union branches: Credit unions can’t compete with the number of physical branches that big banks have. For this reason, you may have to go out of your way to find a credit union in your area.

Best Credit Unions for Personal Loans

Lender	Best For	Loan Amounts	Repayment Terms	APRs
Patelco Credit Union	Overall	$300 to $100,000	6 to 84 months	9.30% to 17.90%
NASA Federal Credit Union	Debt consolidation	$1,000 to $30,000	1 to 84 months	9.84% to 18.00%
PenFed Credit Union	Low interest rates	$300 to $50,000	12 to 60 months	8.99% to 17.99%
Blue Federal Credit Union	Bad credit	$500 to $30,000	12 to 72 months	10.99% to 17.99%
First Tech Federal Credit Union	Secured loans	$500 to $50,000	6 to 84 months	8.49% to 18.00%
Lake Michigan Credit Union	Credit building	$250 to $25,000	1 to 60 months	9.99% to 18.00%
Navy Federal Credit Union	Military members	$250 to $50,000	6 to 180 months	8.99% to 18.00%

Learn more about our picks for the best personal loans from credit unions.

How to Choose a Personal Loan Lender

Before you start requesting quotes for a personal loan, check your credit and determine how big of a loan you’d like to take out. This can help you narrow down your options, since some credit unions might not offer large personal loans. And although your credit score and history are significant factors in your creditworthiness, there are a few instances when a bank or credit union makes more sense.

In general, it’s a good idea to shop around with several lenders to see what rates you can get. In general, banks may offer more convience, while credit unions may offer better rates and lower fees.

Here are a few basic examples:

• Bank: You want to take out a $100,000 loan to complete a home renovation project, but your credit union only lets you borrow up to $50,000.
• Credit union: Your credit score is below average and you can’t qualify with a bank, or you pre-qualify for a loan with a lower rate when rate shopping.
• Bank or credit union: You want a small loan that’s easy to take out, so you choose the bank or credit union you already have a relationship with.

How Do People Use Personal Loans?

To give you an idea of how personal loans can be used, take a look at this national survey commissioned by Investopedia in 2023. The survey revealed that debt consolidation was the primary reason people took out personal loans, followed by home improvement and other large purchases.

Are Credit Unions Better Than Banks for Personal Loans?

Whether credit unions or banks are better depends on your needs and personal finances. For instance, a bank might be a better option if you need to borrow a large amount of money and you have good credit. On the other hand, you might pay less in interest and fees if you take out a loan from your local credit union. That’s why it pays to check your potential rates with a few lenders.

Is It Easier to Get a Personal Loan From a Bank or a Credit Union?

Banks may have more rigorous lending standards, which means they might require higher credit scores. If your credit score needs work, consider applying for a personal loan at a credit union.

Are Interest Rates on Loans Higher at Credit Unions or Banks?

Because banks are looking to generate a profit, they may charge higher interest rates (and often more fees) than credit unions, which are owned by the credit union members and aren’t trying to make a profit.

What’s Best for a Debt Consolidation Loan—a Bank or a Credit Union?

Credit unions tend to offer more competitive interest rates for loans, including debt consolidation loans, but that’s not always the case. Every circumstance is different and rates change regularly, so it’s important to shop around.

The Bottom Line

The best thing you can do before taking out a personal loan is to shop around and check your rates with a handful of lenders. By requesting quotes from banks and credit unions, you can compare interest rates, terms, and fees. Pay attention to added fees and potential discounts before you submit your application to find the best possible offer for your credit and financial situation.

Fact checked by Suzanne Kvilhaug

If you are having trouble with your taxes, tap one of these five free resources for help.

The Internal Revenue Service (IRS) offers two programs to help you do your taxes, the Defense Department backs one, the AARP Foundation runs one, and one is a federal grant program that provides help with tax disputes. All have answers to the tax questions you may be struggling with alone.

Key Takeaways

• Volunteer Income Tax Assistance helps people with incomes up to $67,000, limited English, or disabilities.
• Tax Counseling for the Elderly offers free tax assistance for people 60 and older.
• MilTax offers free one-on-one counseling sessions and free tax software to military members and their families.
• AARP Foundation Tax Aide aims to help people 50 and older with low and moderate incomes, but this free program is open to everyone.
• Low Income Taxpayer Clinics help taxpayers who are having disputes with the IRS. The service is provided for free or for a slight fee.

1. Volunteer Income Tax Assistance (VITA)

This IRS program has been helping taxpayers for more than 50 years. To qualify for this free tax help, you’ll need an income of $67,000 or lower. People with disabilities and people who speak limited English also qualify.

VITA sites are run by IRS partners, and the volunteers who fill out tax returns must pass tax law training that meets the IRS’s standards.

“The volunteer preparers I’ve worked with took the service very seriously, many coming back year after year to help elderly and lower-income taxpayers,” says Mark Rosinski, a certified financial planner with Dunes Financial. “Also, every VITA volunteer is required to pass IRS training before every tax season. And lastly, every return is reviewed by another preparer for a second set of eyes before filing,”

The VITA locator tool allows you to find a Volunteer Income Tax Assistance site near you by searching by zip code.

“If it’s difficult for someone to sit and wait for their return to be completed, many VITA programs now offer a drop-off program. This allows a taxpayer to drop off their documents and come back when completed, saving them time and money.” Rosinski says.

2. Tax Counseling for the Elderly (TCE)

This IRS program provides free tax help for people 60 and up. Questions about pensions and other retirement-related questions are all answered in this free program. The VITA locator tool can be used to find Tax Counseling for the Elderly sites. Like VITA, this program is managed by the IRS, and the program sites are run by IRS partners and volunteers who must pass tax law training that is up to the standards set by the IRS.

3. MilTax Free Tax Services

MilTax provides free tax software and free tax assistance for military members. Military tax experts offer one-on-one help, and the free tax software is designed for the specific tax issues of military life. MilTax helps military members file a federal tax return and up to three state returns. The service is available to military members and their families. For in-person assistance, check the VITA locator for programs on military installations.

4. AARP Foundation Tax Aide

While AARP Foundation Tax Aide offers help to everyone who reaches out, the focus of the program is helping people 50 and up with moderate to low income. Started in 1968, AARP Tax Aide is available in more than 3,600 locations across the United States. Volunteers are certified by the IRS. To find a location near you, use this locator tool.

5. Low Income Taxpayer Clinics (LITC)

These clinics offer tax help for people with low incomes who have tax disputes with the IRS. Tax services are free or for a small fee. The disputed tax amount is typically below $50,000. A clinic locator is found on the program’s website. Low Income Taxpayer Clinics also provide outreach to people who speak English as a second language.

The Bottom Line

With April 15 around the corner, it is not too late to reach out for some free tax help in filing your return. Which free service is right for you? Volunteer Income Tax Assistance is for people with disabilities, limited English, and those who make up to $67,000 a year. Tax Counseling for the Elderly offers tax assistance for people 60 and up.

AARP Foundation Tax Aide is free and open to everyone, but it aims to help taxpayers 50 and older with low and moderate incomes. MilTax offers free tax help, including free tax software, to military members and their families. If you have a dispute with the IRS, contact Low-Income Taxpayer Clinics. You’ll get tax assistance for free or a modest fee.

Reviewed by Lea D. Uradu
Fact checked by Suzanne Kvilhaug

If you are a financial professional and wish to work as an investment adviser to help individual investors manage assets their assets, or provide financial counsel, you generally need to become an investment adviser representative (IAR) under a registered investment adviser (RIA) firm.

An RIA is a firm registered with the Securities and Exchange Commission (SEC) or a state securities regulator to offer advisory services for a fee. An IAR is an individual who works for a RIA firm and has passed the necessary licensing requirements to offer investment advice. So, while the two terms and their acronym may look similar, there are important distinctions between them.

RIAs and IARs have a fiduciary duty to act in the best interest of the client and disclose any conflicts of interest. They also have specific requirements and regulations that can differ from some other types of financial advisors.

Key Takeaways

• Registered investment advisors (RIAs) are financial firms
• To form an RIA, investment advisors must pass the Series 65 exam (or equivalent).
• RIAs must register with the SEC or state authorities, depending on the amount of money they manage.
• Applying to become an RIA includes filing a Form ADV, which includes a disclosure document that is also distributed to all clients.
• Usually compensated by a percentage of assets under management, RIAs are legally required to act in a fiduciary capacity for their clients at all times.

Licensing and Qualifications

The first step to starting an RIA is for you to pass the Series 65 or Uniform Investment Advisor Law exam so that you can become an IAR. The Series 65 test is given by the Financial Industry Regulatory Authority (FINRA). The test itself covers federal securities laws and other topics related to investment advice. It has 140 multiple-choice questions, of which 10 are pretest questions that will not count toward final grade. Of the 130 scored questions, a candidate must correctly answer 92 to pass the three-hour exam.

While no other designations are required to become an IAR, most advisors will find it rather difficult to bring in business without additional qualifications. These can include other FINRA exams, such as the Series 6 or Series 7, and credentials, such as the certified financial planner (CFP) or certified financial advisor (CFA). In fact, many states allow advisors who carry the following designations in good standing to waive the Series 65. These designations include the following:

• CFP
• CFA
• Chartered investment counselor
• Chartered financial consultant
• Personal financial specialist

Here’s a list of the major terms for securities professionals:

Securities Professionals and Their Firms
Attributes	Registered Representative (RR)	Broker-Dealer (BD)	Investment Adviser Representative (IAR)	Registered Investment Adviser (RIA)
Also known as	Stockbroker	Securities dealer	Financial adviser	Financial advisory, wealth manager
Primary Regulating Bodies	FINRA	FINRA, SEC	SEC, state regulators	SEC, state regulators
Primary Services	Buying and selling securities on behalf of clients	Facilitating trading of securities	Providing financial advice and planning services	Managing investment portfolios and providing financial advice
Compensation	Commissions	Fee-based or Commission-based	Fee-based	Fee-based
Examples	Employees of major brokerages like Morgan Stanley	Morgan Stanley, Merrill Lynch, Edward Jones, UBS, Wells Fargo, as well as independent broker-dealers (IBDs)	Employees for firms like Merrill Lynch, JPMorgan, and independent RIAs.	Merrill Lynch, JPMorgan, and independent RIAs.

Federal and State Registration for RIAs

If providing investment advice or asset management services is vital to your services, the next step to becoming an RIA is to register your firm with either the SEC or the state(s) where you’ll be doing business.

Series 65 test-takers are not required to be sponsored by a broker-dealer, as they are for most other securities-related exams administered by FINRA.

However, you will not have to do this if providing investment services or advice is purely incidental to your practice. Professionals who are often exempt under this exception include the following:

• Accountants
• Attorneys
• Engineers
• Teachers
• Bankers
• Broker-dealers
• Publishers
• Advisors who work only with U.S. government securities
• Advisors who are registered with the Commodity Futures Trading Commission and for whom providing investment advice is not a primary line of business
• Employees of charitable organizations

SEC Registration Eligibility

Here are the SEC requirements on the type of registration an RIA needs, which depend on how much in assets you manage:

• Under $25 million of assets under management (AUM): A small adviser with less than $25 million in AUM is prohibited from SEC registration if its principal office and place of business are in a state that regulates advisers (all states except Wyoming).
• Between $25 million and $100 million of AUM:
• Required to register with the SEC if its principal office and place of business is in New York or Wyoming unless otherwise exempted.
• Prohibited from SEC registration if its principal office and place of business are in any state except New York or Wyoming, and the midsized adviser is required to be registered in that state. If the midsized adviser is not required to be registered in that state, then the adviser must register with the SEC, unless a registration exemption is available.
• Between $90 million and $110 million of AUM:
• May register with the SEC when it reaches $100 million of AUM.
• Must register with the SEC once it reaches $110 million of AUM, unless otherwise exempted.
• Once registered with the SEC, is not required to withdraw from SEC registration and register with the states until the adviser goes lower than $90 million of AUM.
• Over $110 million in AUM: A large adviser with at least $110 million of AUM is required to register with the SEC, unless otherwise exempted.

Any firm or individual who acts as an investment advisor on behalf of an investment company is also required to file with the SEC, no matter the amount of AUM.

Firms that register with the SEC are not required to file with states, but they must file a notice of SEC registration with each state where they do business. Most states don’t require registration or filing of notice if the advisor has less than five clients in the state and does not have a place of business there.

Most firms register with these entities as corporations, with each advisor acting as an investment advisor representative (IAR).

RIAs and Form ADV

The next step in registering is to create an account with the Investment Adviser Registration Depository (IARD), which FINRA manages on behalf of the SEC and states. (A few states do not require this, so advisors who only do business in those do not have to go through this process.) Once the account is open, FINRA will supply the advisor or firm with a CRD number and account ID information. Then, the RIA can file Form ADV and the U4 forms with either the SEC or states.

Form ADV is the official application document for applying to become an RIA. It has several sections, and all must be completed, although only the first section is electronically submitted to the SEC or state government for approval. Part II of the form serves as a disclosure document that is distributed to all clients. It must clearly list all services supplied to clients, as well as a breakdown of compensation and fees, possible conflicts of interest, the firm’s code of ethics, the advisor’s financial condition, educational background and credentials, and any affiliated parties.

Important

Form ADV must also be uploaded electronically into the IARD and made available to all new and prospective clients. Preparing and submitting these forms typically takes most firms a few weeks, and the SEC must respond to the application within 45 days.

Some states may respond as soon as 30 days, but requests for additional information often delay the process. All firms that register with the SEC must also create a comprehensive compliance program that covers all aspects of their practice, from trading and account administration to sales and marketing and internal disciplinary procedures.

Once the SEC approves an application, the firm can start work as an RIA, filing annual amendments to Schedule 1 of the ADV and updating all of the firm’s relevant information (such as the AUM). In addition, while the SEC has no specific financial or bonding requirements for advisors, such as a minimum net worth or cash flow, it does examine the advisor’s financial condition during the application process.

Most states require RIAs to have a net worth of at least $35,000 if they have custody of client funds and $10,000 if they do not. RIAs who fail to meet this requirement must post a surety bond. (The rules for this requirement and several other aspects of registration vary from state to state.)

IARs vs. RRs

Financial professionals become IARs and establish RIAs because it allows them greater freedom to structure their practices—more so than for RRs who also advise and buy and sell securities for individual investors, usually as employees of brokerage firms.

RRs who work for broker-dealers—aka stockbrokers—pay a percentage of their earnings as compensation for their back-office support and compliance oversight.

Brokers also usually work on commission, while most RIAs charge their customers either a percentage of assets under management or a flat or hourly fee for their services. Many RIAs also use another firm, a custodian like Schwab or Fidelity, to house their clients’ assets instead of holding the accounts in-house. This simplifies recordkeeping and administration.

Important

Despite the similar-sounding names, registered representatives (RRs) are not the same as investment advisor representatives (IARs). RRs work for a brokerage firm, serving as its representative for clients trading investments. Brokers are RRs.

Fiduciary Standard

Although the SEC and the states have the responsibility of overseeing RIAs, FINRA has tried at various points to get Congress to let it take on the task. Advisors see FINRA substantially lowering the protection given to RIA clients, as RIAs are legally required to act in a fiduciary capacity for their clients at all times. Brokers and securities licensed reps only have to meet the suitability standard, which only requires that a given transaction performed by a broker must be “suitable” for the client at that time.

What Are the Primary Steps To Becoming an RIA?

Establishing an RIA involves several key steps. First, you need to pass the Series 65 exam or have a valid Series 7 and Series 66, as this is required by most states. Second, draft your firm’s compliance documents, including Form ADV Parts 1 and 2, which describe the nature of your business, types of clients, fees, and potential conflicts of interest. Then, register with the SEC or state regulator by filing the Form ADV along with other required forms. Finally, carry out an ongoing compliance program to follow SEC regulations.

How Much Does It Cost To Start an RIA?

Costs to start an RIA can vary widely depending on a number of factors, including state registration fees, legal and compliance consulting fees, technology costs, and operational expenses. Generally, the startup cost can range from $10,000 to $50,000. However, ongoing costs such as compliance, technology, and staffing should also be considered in the budget.

Can I Operate My Ria in More Than One State?

Yes. Nevertheless, each state will have its own registration requirements, so you’ll need to ensure you follow the regulations in each state where you do business. If your RIA manages $100 million or more in client assets, you can register with the SEC at the federal level instead of with state securities authorities, which will allow you to offer services in multiple states more easily.

What Is the Fiduciary Duty of an RIA and Why Is It Important?

The fiduciary duty of an RIA is a legal obligation to act in the best interests of its clients. This means an RIA must provide investment advice that best meets the client’s needs, even if it’s not in the RIA’s own best interest. This is important as it ensures that the advice provided to clients is based only on their needs, goals, and risk tolerance, which helps to build trust and confidence in the relationship.

The Bottom Line

Registered Investment advisors enjoy greater freedom than their counterparts in the industry who work on commission. They are also required to adhere to a much higher standard of conduct, and most advisors feel strongly that this should not change.

Of course, those who register to become RIAs must also contend with the normal startup issues that most new business owners face, such as marketing, branding, and location, in addition to the registration process.

Reviewed by Amy Drury
Fact checked by Suzanne Kvilhaug

A company needs financial capital to operate its business. For most companies, financial capital is raised by issuing debt securities and by selling common stock. The amount of debt and equity that makes up a company’s capital structure has many risk and return implications. Therefore, corporate management must use a thorough and prudent process for establishing a company’s target capital structure. The capital structure is how a firm finances its operations and growth by using different sources of funds.

What You Need to Know

• A company’s capital structure is the mix of debt and equity that are used to finance its spending.
• A company’s financial leverage is the amount of debt and preferred stock in its capital structure, as opposed to common equity.
• A high degree of financial leverage can be a good thing, if it is used to purchase productive assets.
• However, an over-leveraged company can also increase its financial risk.

Use of Financial Leverage

Financial leverage is the extent to which fixed-income securities and preferred stock are used in a company’s capital structure. Financial leverage has value due to the interest tax shield that is afforded by the U.S. corporate income tax law. The use of financial leverage also has value when the assets that are purchased with the debt capital earn more than the cost of the debt that was used to finance them.

Under both of these circumstances, the use of financial leverage increases the company’s profits. With that said, if the company does not have sufficient taxable income to shield, or if its operating profits are below a critical value, financial leverage will reduce equity value and thus reduce the value of the company. 

Given the importance of a company’s capital structure, the first step in the capital decision-making process is for the management of a company to decide how much external capital it will need to raise to operate its business. Once this amount is determined, management needs to examine the financial markets to determine the terms in which the company can raise capital. This step is crucial to the process because the market environment may curtail the ability of the company to issue debt securities or common stock at an attractive level or cost.

With that said, once these questions have been answered, the management of a company can design the appropriate capital structure policy and construct a package of financial instruments that need to be sold to investors. By following this systematic process, management’s financing decision should be implemented according to its long-run strategic plan, and how it wants to grow the company over time.

The use of financial leverage varies greatly by industry and by the business sector. There are many industry sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by many companies in these sectors has played a paramount role in forcing a lot of them to file for Chapter 11 bankruptcy.

Examples include R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co. (A&P) (2010), and Midwest Generation (2012). Moreover, excessive use of financial leverage was the primary culprit that led to the U.S. financial crisis between 2007 and 2009. The demise of Lehman Brothers (2008) and a host of other highly levered financial institutions are prime examples of the negative ramifications that are associated with the use of highly levered capital structures.

The Modigliani and Miller Theorem on Corporate Capital Structure

The study of a company’s optimal capital structure dates back to 1958 when Franco Modigliani and Merton Miller published their Nobel Prize-winning work “The Cost of Capital, Corporation Finance, and the Theory of Investment.” As an important premise of their work, Modigliani and Miller illustrated that under conditions where corporate income taxes and distress costs are not present in the business environment, the use of financial leverage does not affect the value of the company. This view, known as the Irrelevance Proposition theorem, is one of the most important pieces of academic theory ever published. 

Unfortunately, the Irrelevance Theorem, like most Nobel Prize-winning works in economics, requires some impractical assumptions that need to be accepted to apply the theory in a real-world environment. In recognition of this problem, Modigliani and Miller expanded their Irrelevance Proposition theorem to include the impact of corporate income taxes, and the potential impact of distress cost, for purposes of determining the optimal capital structure for a company.

Their revised work, universally known as the Trade-off Theory of capital structure, makes the case that a company’s optimal capital structure should be the prudent balance between the tax benefits that are associated with the use of debt capital, and the costs associated with the potential for bankruptcy for the company. Today, the premise of the Trade-off Theory is the foundation that corporate management should use to determine the optimal capital structure for a company.

Impact of Financial Leverage on Performance

Perhaps the best way to illustrate the positive impact of financial leverage on a company’s financial performance is by providing a simple example. The Return on Equity (ROE) is a popular fundamental used in measuring the profitability of a business as it compares the profit that a company generates in a fiscal year with the money shareholders have invested. After all, the goal of every business is to maximize shareholder wealth, and the ROE is the metric of return on shareholder’s investment.

In the table below, an income statement for Company ABC has been generated assuming a capital structure that consists of 100% equity capital. The capital raised was $50 million. Since only equity was issued to raise this amount, the total value of equity is also $50 million. Under this type of structure, the company’s ROE is projected to fall between the range of 15.6% and 23.4%, depending on the level of the company’s pre-tax earnings.

In comparison, when Company ABC’s capital structure is re-engineered to consist of 50% debt capital and 50% equity capital, the company’s ROE increases dramatically to a range that falls between 27.3% and 42.9%.

As you can see from the table below, financial leverage can be used to make the performance of a company look dramatically better than what can be achieved by solely relying on the use of equity capital financing.

Since the management of most companies relies heavily on ROE to measure performance, it is vital to understand the components of ROE to better understand what the metric conveys.

A popular methodology for calculating ROE is the utilization of the DuPont Model. In its most simplistic form, the DuPont Model establishes a quantitative relationship between net income and equity, where a higher multiple reflects stronger performance. However, the DuPont Model also expands upon the general ROE calculation to include three of its parts. These parts include the company’s profit margin, asset turnover, and equity multiplier. Accordingly, this expanded DuPont formula for ROE is as follows:

$begin{aligned} text{Return on equity} &= frac{text{Net Income}}{text{Equity}}\ &=frac{text{Net Income}}{text{Sales}} times frac{text{Sales}}{text{Assets}} times frac{text{Assets}}{text{Equity}}\ end{aligned}$Return on equity​=EquityNet Income​=SalesNet Income​×AssetsSales​×EquityAssets​​

Based on this equation, the DuPont Model illustrates that a company’s ROE can only be improved by increasing the company’s profitability, by increasing its operating efficiency or by increasing its financial leverage.

Measuring Financial Leverage Risk

Corporate management tends to measure financial leverage by using short-term liquidity ratios and long-term capitalization, or solvency ratios. As the name implies, these ratios are used to measure the ability of the company to meet its short-term obligations. Two of the most utilized short-term liquidity ratios are the current ratio and acid-test ratio. Both of these ratios compare the company’s current assets to its current liabilities.

However, while the current ratio provides an aggregated risk metric, the acid-test ratio provides a better assessment of the composition of the company’s current assets for purposes of meeting its current liability obligations since it excludes inventory from current assets. 

Capitalization ratios are also used to measure financial leverage. While many capitalization ratios are used in the industry, two of the most popular metrics are the long-term-debt-to-capitalization ratio and the total-debt-to-capitalization ratio. The use of these ratios is also very important for measuring financial leverage. However, it’s easy to distort these ratios if management leases the company’s assets without capitalizing on the assets’ value on the company’s balance sheet. Moreover, in a market environment where short-term lending rates are low, management may elect to use short-term debt to fund both its short- and long-term capital needs. Therefore, short-term capitalization metrics also need to be used to conduct a thorough risk analysis.

Coverage ratios are also used to measure financial leverage. The interest coverage ratio, also known as the times-interest-earned ratio, is perhaps the most well-known risk metric. The interest coverage ratio is very important because it indicates a company’s ability to have enough pre-tax operating income to cover the cost of its financial burden.

The funds-from-operations-to-total-debt ratio and the free-operating-cash-flow-to-total-debt ratio are also important risk metrics that are used by corporate management. 

Factors in the Capital Structure Decision-Making Process

Many quantitative and qualitative factors need to be taken into account when establishing a company’s capital structure. First, from the standpoint of sales, a company that exhibits high and relatively stable sales activity is in a better position to utilize financial leverage, as compared to a company that has lower and more volatile sales.

Second, in terms of business risk, a company with less operating leverage tends to be able to take on more financial leverage than a company with a high degree of operating leverage.

Third, in terms of growth, faster-growing companies are likely to rely more heavily on the use of financial leverage because these types of companies tend to need more capital at their disposal than their slow growth counterparts.

Fourth, from the standpoint of taxes, a company that is in a higher tax bracket tends to utilize more debt to take advantage of the interest tax shield benefits.

Fifth, a less profitable company tends to use more financial leverage, because a less profitable company is typically not in a strong enough position to finance its business operations from internally generated funds.  

The capital structure decision can also be addressed by looking at a host of internal and external factors. First, from the standpoint of management, companies that are run by aggressive leaders tend to use more financial leverage. In this respect, their purpose for using financial leverage is not only to increase the performance of the company but also to help ensure their control of the company.

Second, when times are good, capital can be raised by issuing either stocks or bonds. However, when times are bad, suppliers of capital typically prefer a secured position, which, in turn, puts more emphasis on the use of debt capital. With this in mind, management tends to structure the capital makeup of the company in a manner that will provide flexibility in raising future capital in an ever-changing market environment.

Why Is Financial Leverage Bad?

Financial leverage refers to the amount of debt or debt-like instruments that a company uses to raise capital, as opposed to selling common stock. Since these costs must be repaid, a high degree of leverage increases the burden on a company’s finances and increases the likelihood that it will default on its obligations.

How Do You Calculate a Company’s Leverage Ratio?

There are several metrics to measure a company’s financial leverage, depending on whether the focus is on the company’s equity, assets, or earnings. Perhaps the most frequently-used one is the debt-to-equity ratio, which measures a company’s debt relative to its shareholder’s equity.

What Is the Optimal Financial Leverage Ratio?

There’s no hard rule about what make’s a “good” financial leverage level for a company’s capital structure, and different industries have different sources of capital. The easiest way to tell if a company is over-leveraged is to compare it with other companies in the same industry and see if they use a similar mix of debt and equity financing.

The Bottom Line

In essence, corporate management utilizes financial leverage primarily to increase the company’s earnings per share and to increase its return-on-equity. However, with these advantages come increased earnings variability and the potential for an increase in the cost of financial distress, perhaps even bankruptcy.

With this in mind, the management of a company should take into account the business risk of the company, the company’s tax position, the financial flexibility of the company’s capital structure, and the company’s degree of managerial aggressiveness when determining the optimal capital structure.

Reviewed by Michael J Boyle
Fact checked by Timothy Li

Recessions seem to occur every decade or so in modern economies, and they seem to regularly follow periods of strong economic growth. This pattern recurs with striking consistency, but is it inevitable? Can a recession be avoided, or is it an unavoidable feature of a modern capitalist economy?

Key Takeaways

• Modern, capitalist economies exhibit readily observable cycles of booming growth followed by periods of recession and eventual recovery.
• Many people assume that these cycles are more or less inevitable.
• Understanding what causes recessions is the key to knowing whether they are inevitable.
• Numerous explanations for recessions have been proposed, focusing on different factors in the economy.
• The most powerful and comprehensive of these theories implies that while recessions are not logically inevitable, they are here to stay, given current economic circumstances.

What Is a Recession?

A recession is an economic period marked by negative real growth, declining output, depressed prices, and rising unemployment, which often follows a period of strong economic growth as measured by these same variables. Recessions are characterized by an unusual, simultaneous, and large grouping of business errors, which some economists call “malinvestments.”

Faced with financial loss and declining margins, businesses scale back production or fail entirely, and business managers (or the new owners) reallocate resources tied up in the failed projects to different uses. During the period of transition, some of these resources will need to be repriced (in terms of goods prices, asset values, or in the case of labor, wages), and some will remain idle for some time until a new use is found. As this process proceeds, the economy recovers.

Note

The National Bureau of Economic Research (NBER) determined that February 2020 was officially the peak and end of economic expansion that started following the Great Recession, as the U.S. economy contracted in the wake of the COVID-19 pandemic. At two months, the recession that came after was the shortest on record, lasting from February 2020 to April 2020.

Causes of Recessions

The key issue as to whether this process of growth to recession to recovery is inevitable is: What causes the cluster of business errors to occur? Why can businesses not continue to grow and asset prices continue to rise indefinitely?

Economists have developed numerous explanations for these clusters of business failures. Some rely on psychological factors. These explanations point out that people can be prone to excessive optimism and confidence or pessimism and fear, leading to the propagation and collapse of market bubbles and persistent deficiencies of aggregate demand.

Some of this can even be reproduced experimentally through simulations or experiments on a very limited scale. Such theories are popular, but in general fail to actually explain how a large-scale cluster of business errors can occur across markets and asset classes in an entire economy, as happens during a recession.

Others point to economic shocks, which are random events such as wars or epidemics, that can negatively affect production, consumer demand, or the costs of key goods and commodities in an economy. These kinds of things can certainly hurt businesses across an economy all at once. However, it doesn’t explain why recessions seem to occur with such regularity or why they consistently follow periods of notably strong growth. After all, economic shocks are, by nature, random events. There is no particular reason for random shocks to follow patterns like these, which are easily observed. Random negative shocks may be inevitable, but that doesn’t show why the observed boom-and-bust patterns in the economy should be inevitable.

Other economists explain the recurrent cycle of growth and recession in purely financial terms. These often involve errors by the central bank or monetary authority that supplies money to the economy. Maybe too much new money leads to excessive inflation, but too little may lead to tightening credit conditions and defaults leading to debt deflation, and this is why we have recessions.

Each of these types of explanations for the cycle of growth and recession that can be seen over the decades seems to have some power and perhaps some bit of truth. But none of them really shows that recessions are inevitable, or that a cycle of expansion and contraction in the economy should really exist at all.

These theories fail to explain why monetary authorities should err so greatly and with such apparent regularity as to cause a readily visible cycle of boom and bust in the economy. Essentially these theories simplify the question from “Why do clusters of severe business errors occur?” to “Why should severe clusters of central bank errors occur with such regularity?”

An Alternative Explanation

Another alternative explanation for recessions comes from Austrian Business Cycle Theory (ABCT). This theory takes a deeper look at many of the factors discussed above. It focuses on how central banking and monetary policy interact with real economic events and the psychology and incentives faced by investors, producers, and consumers in the economy. By looking at how all these things relate to each other, we can get a more complete view of how business cycles work and whether they are inevitable.

In ABCT, the key cause of recessions is the creation of new money in the form of loans and corresponding deposits by the banking system, known as fiduciary media of exchange. Banks, and especially central banks, do this not out of an error in calculating the correct monetary policy, but because it is their essential business model. This sets in motion a series of investments in the economy by distorting the incentives of investors, consumers, and savers in favor of debt-financed investment and consumption and a simultaneous decrease in savings. 

Note

The expansion of credit in the banking system sets in motion the cycle of boom and inevitable bust.

This creates a temporary illusion of a strong economy as prices and spending across the economy rise—but because the plans of investors, consumers, and savers are fundamentally in conflict, this illusion cannot last. Business investment projects previously expected to be profitable under the illusion of distorted incentives and the optimistic exuberance of the boom are eventually revealed to be a cluster of errors.

Often, this revelation of the cluster of errors may be triggered in part by some random economic shock, but not necessarily. The conflicts that arise as investors, consumers, and savers try to increase both present and future consumption while decreasing savings often take the form of real constraints and bottlenecks in supply chains that may resemble random economic shocks, though they are nonetheless systematically caused by the initial overissuance of new money and credit. These lead to business failures, rising unemployment, debt deflation, and all the economic pain of a recession.

Recessions Are Inevitable—at Least for Now

In the end, once the process of the artificial boom in the economy by the issuance of credit is set in motion, then the ensuing bust and recession are indeed inevitable. But this does not mean that recessions are always and generally inevitable, other than after episodes of inappropriate creation of money and credit. Recessions are not logically inevitable in any economy, but are contingent upon the monetary practices and institutions that a society adopts. 

However, for better or for worse, all modern, capitalist economies include banking systems based on fractional reserve lending coordinated by central banks that routinely and continuously issue new fiduciary media into the economy. As long as this is the case, then the cycles of boom and bust that we regularly experience, as described by ABCT, will unfortunately be inevitable. Given the ubiquity and entrenched position of the current monetary arrangements, for now, recessions are just part of how our economy works.

Important

For the time being, given existing monetary institutions, recessions are inevitable.

Why Are There Always Booms and Busts in the Economy?

There are natural tendencies for the economy to experience booms and busts due to the way that modern capitalism functions. During periods of growth and expansion, firms may begin overproducing goods, increasing aggregate supply relative to actual demand. Banks, likewise, may overextend credit to borrowers who might have gotten in over their heads. This leads to businesses going bankrupt and/or having to sell assets at low prices to raise cash to pay their debts.

As prices fall across the board in response to excess supply or excessive debts in the business sector, this sets off a chain reaction throughout the economy as producers cut back production in the face of falling prices, leading to layoffs and more bankruptcies. Eventually, the economy contracts back to something closer to a normal level of production and employment.

What Causes a Recession?

A recession occurs when economic output declines from one period to the next, but recessions can be caused by several factors affecting the economy.

Sometimes a downturn can be triggered by a financial crisis or a large fall in asset prices, such as housing or other investments. Other times, it can be due to a structural change, such as a shift in the composition of an economy from producing goods toward producing services or vice versa. Another cause can be a natural event like an earthquake or a drought that causes a decline in the production of key goods and services.

How Do Central Banks and Governments Fight Recessions?

While recessions may be somewhat natural in terms of macroeconomic cycles, governments and central banks can and do intervene to both lessen the severity and duration of an economic downturn. Central banks like the Federal Reserve can enact an accommodative monetary policy, such as lowering interest rates to make it easier to borrow for consumption and investment. The government can also enact expansionary fiscal policy such as lowering taxes and increasing federal spending to spur aggregate demand.

The Bottom Line

Recessions, or economic contractions, are likely an inevitable function of the usual operations of a modern capitalistic economy. Unfortunately, recessions can lead to high levels of unemployment, lower asset prices, investment losses, and firms going out of business. But they also show us something very important about how modern economies work: that unchecked growth and credit expansion funded by banks is unsustainable when it occurs without regard for fundamental constraints on the supply of goods and services.

Reviewed by Amy Drury
Fact checked by Michael Rosenston

What Are Dividends?

A dividend is a method of redistributing a company’s profits to shareholders as a reward for their investment. Companies are not required to issue dividends on common shares of stock, though many pride themselves on paying consistent or constantly increasing dividends each year. When a company issues a dividend to its shareholders, the dividend can be paid either in cash or by issuing additional shares of stock. The two types of dividends affect a company’s balance sheet in different ways.

Key Takeaways:

• Companies issue dividends to reward shareholders for their investment.
• Dividends paid can be in the form of cash or additional shares called stock dividends.
• Cash dividends affect the cash and shareholder equity on the balance sheet; retained earnings and cash are reduced by the total value of the dividend.
• Stock dividends have no impact on the cash position of a company. They are deducted from retained earnings, and impact the shareholders equity section of the balance sheet. 

Understanding Dividends

When most people think of dividends, they think of cash dividends. However, companies can also issue stock dividends. When a company issues a stock dividend, it distributes additional quantities of stock to existing shareholders according to the number of shares they already own. Stock dividends impact the shareholders’ equity section of the corporate balance sheet, while cash dividends reduce retained earnings.

Retained Earnings on the Balance Sheet

Retained earnings are the amount of money a company has left over after all of its obligations have been paid. Retained earnings are typically used for reinvesting in the company, paying dividends, or paying down debt. While net profit is the amount of income that remains after accounting for the cost of doing business in a given period, retained earnings are the amount of income accrued over the years that has not been reinvested in the business or distributed to shareholders.

Cash Dividends on the Balance Sheet

Cash dividends affect two areas on the balance sheet: the cash and shareholders’ equity accounts. Investors will not find a separate balance sheet account for dividends that have been paid. However, after the dividend declaration and before the actual payment, the company records a liability to its shareholders in the dividend payable account.

After the dividends are paid, the dividend payable is reversed and is no longer present on the liability side of the balance sheet. When the dividends are paid, the effect on the balance sheet is a decrease in the company’s retained earnings and its cash balance. In other words, retained earnings and cash are reduced by the total value of the dividend.

By the time a company’s financial statements have been released, the dividend is already paid, and the decrease in retained earnings and cash are already recorded. In other words, investors will not see the liability account entries in the dividend payable account. 

For example, assume a company has $1 million in retained earnings and issues a 50-cent dividend on all 500,000 outstanding shares. The total value of the dividend is $0.50 x 500,000, or $250,000, to be paid to shareholders. As a result, both cash and retained earnings are reduced by $250,000 leaving $750,000 remaining in retained earnings.

The ultimate effect of cash dividends on the company’s balance sheet is a reduction in cash for $250,000 on the asset side, and a reduction in retained earnings for $250,000 on the equity side.

Stock Dividends on the Balance Sheet

While cash dividends have a straightforward effect on the balance sheet, the issuance of stock dividends is slightly more complicated. A company’s executive management might want to issue stock dividends to its shareholders if the company lacks excess cash on hand or if they want to decrease the value of existing shares, driving down the price-to-earnings ratio (P/E ratio) and other financial metrics. Stock dividends are sometimes referred to as bonus shares or a bonus issue.

Stock dividends have no impact on the cash position of a company and only impact the shareholders’ equity section of the balance sheet. The larger the dividend the larger the impact on the share price. A stock split may seem similar, but it is different because it dividends existing shares, and a dividend hands out new shares.

When a stock dividend is declared, the total amount to be debited from retained earnings is calculated by multiplying the current market price per share by the dividend percentage and by the number of shares outstanding. If a company pays stock dividends, the dividends reduce the company’s retained earnings and increase the common stock account. Stock dividends do not result in asset changes to the balance sheet but rather affect only the equity side by reallocating part of the retained earnings to the common stock account.

For example, say a company has 100,000 shares outstanding and wants to issue a 10% dividend in the form of stock. If each share is currently worth $20 on the market, the total value of the dividend would equal $200,000. The two entries would include a $200,000 debit to retained earnings and a $200,000 credit to the common stock account. The balance sheet would be balanced following the entries.

Virtually trade stocks, options, and cryptocurrency

Fact checked by Yarilet Perez
Reviewed by Margaret James

The Investopedia Simulator is designed to help anyone learn the mechanics of buying and selling securities in a risk-free environment by simulating activities investors experience when placing orders through a broker.

The Investopedia Simulator will track the value of a user’s portfolio when adding or closing positions. Users can also compare results to other practicing investors’ performances through Simulator games.

Key Takeaways

• The Investopedia Simulator is a virtual trading tool designed to help potential investors improve their skills at trading and investing.
• It has powerful tools for conducting research and placing simulated trade orders.
• It tracks the value of investing positions close to real-time.
• Simulator users can participate in games in which they compare their investment performance to those of others.

Getting Started 

To access the Simulator, create an account by clicking Get Started. The free account only requires an email, username, and password.

A new account has a default virtual balance of $100,000 to buy virtual shares that track the same as real shares. It is easy to discover how the Investopedia Simulator works just by exploring the interface and trying out its functions for Stocks and Crypto. Users are directed to Your Portfolio. On the top right, two options allow users to toggle.

Stocks Simulator

The Stocks interface includes four functional areas: portfolio, trade, research, and games.

• Portfolio: List the positions users are holding and the current value of those positions based on market data.
• Trade: Permits users to see price quotes and place orders like the functionality of an actual broker.
• Research: Helps users study price charts and review company information behind the stocks available for simulated trading.
• Games: Users can join up with simulated investing competitions or even start one of their own.  

Note

The portfolio section shows performance history, including annualized returns, remaining cash, and buying power. The historical trade data can be sorted into stocks, options, and short-selling positions. A small panel displays the user’s rank among all other active Simulator users.  

How and What to Trade

Investors may review the business statements of a company before deciding to buy stock. This fundamental analysis helps investors put money into a stock with a long-term investing strategy. Other investors are comfortable simply reviewing price charts and conducting technical analyses of stocks. 

The Investopedia Simulator’s research section helps users by clicking on one of the ticker symbols displayed on the research page. A stock screener is included so users can specify one or more attributes of companies they’d like to research.

Selecting the trade tab helps users execute orders. Users specify whether they are making a stock or option trade and then specify the ticker symbol or the underlying stock of the option contracts they want to trade.

Users can review the price at which the stock is currently trading. Trading actions include: buying, selling, shorting, or buying to cover. This is the same functionality on retail broker accounts with margin trading. However, only the most common three order types used in retail broker accounts are available: market, limit, or stop orders. The Simulator runs on data that is delayed by about 20 minutes.

Important

A max link allows users to see the maximum number of shares they can buy based on the available virtual cash in the Simulator account. Users who want a portfolio with more than one stock position should avoid buying the maximum number of shares. 

Using the Simulator With a Group

The Investopedia Simulator hosts investing contests among friends, colleagues, and classmates. The Simulator’s functions make these games easy to get started and conduct. Both stock and option trades can be included in the challenge for a wider range of experiences.  

For use by friends, family, students, and the like, the Simulator uses the Investopedia Trading Game as the default starting contest. However, users can join any of the thousands of public games that run without an end date. In the Games section, search for games in the Join Game section. Users can be members of multiple games simultaneously.

Create a Stock Trading Game

To get started, click Games and then click Create Game. Each game has optional features that increase the Simulator experience’s realism. There are tooltips throughout the form that appear. Users can click on the little blue “i” next to words for a detailed explanation of what each field is for and then choose the following:

• Game name: Make it something the group will remember and is unique.
• Game description: What should the group know about the purpose and goals of the game?
• Game type: Is the game’s membership exclusive or something anyone can join?
• Starting cash: By default, everyone gets $100,000 to start, but users can increase or decrease the amount to between $1,000 and $1 million.
• Date range: When will the game begin and end?
• Trading features: Will the group be able to trade on margin, short sell, or trade options? Can members view each other’s portfolios?
• Advanced game rules: Users can determine market delay, commissions, forced diversification, minimum pricing, quick sell restrictions, margin rules, and more.

Click Create Game. Private games require a password. Leaders should provide the group with instructions that include the game name, password, and other specifics such as date range and starting cash. To track the group’s performance, check the Leaderboard under Games.

Crypto Simulator

The crypto environment in the Investopedia Simulator allows users to look up and trade 25 of the most popular cryptocurrencies. The top 11 coins featured are:

• Bitcoin (BTC)
• Ethereum (ETH)
• Tether (USDT)
• USD Coin (USDC)
• BNB (BNB)
• Binance USD (BUSD)
• XRP (XRP)
• Cardano (ADA)
• Solana (SOL)
• Dogecoin (DOGE)
• Polkadot (DOT)

When users click the Trade button, it brings up this list with the financial details about the coin, including price, percentage change, market cap, launch date, circulating supply, total supply, 52-week high and low, today’s high and low, and previous close. Within a crypto portfolio, users can track the performance of their trades over the last week, month, three months, six months, and one year.

Are There Classes Available on How to Trade Stocks?

Yes. Classes are available from companies such as Udemy or at the university level. A high-quality online stock trading course partners well when using a stock simulator.

Are There Other Stock Trading Simulators?

While Investopedia offers one of the best options on the market, it is not the only paper-trading platform. Charles Schwab offers Thinkorswim, and the SIFMA Foundation offers The Stock Market Game.

What Does Paper Trading Mean?

A simulated stock trading platform is a paper trading platform. A paper trade is a simulated trade that allows investors to practice buying and selling financial assets without risking real money. They are an excellent way to test a new investment strategy or to learn how the financial markets work.

The Bottom Line

The Investopedia Simulator allows interested investors to practice trading skills no matter their level of investing experience. Users have access to research tools, the ability to see the value of investing positions, and the opportunity to compete with other users.

Reviewed by Amy Drury
Fact checked by Vikki Velasquez

Gearing ratios form a broad category of financial ratios, of which the debt-to-equity ratio is the predominant example. Accountants, economists, investors, lenders, and company executives use gearing ratios to measure the relationship between owners’ equity and debt.

Gearing ratios are one way to differentiate financially healthy companies from troubled ones. All companies balance the advantages of leveraging their assets with the disadvantages of borrowing risks.

Key Takeaways

• Gearing ratios constitute a broad category of financial ratios.
• The debt-to-equity ratio is a gearing ratio.
• Accountants, economists, investors, and other financial professionals use gearing ratios to measure the relationship between owners’ equity and debt.

Gearing vs. Leverage

“Gearing” refers to the use of debt. Gearing is a leverage analysis of the owner’s equity, often expressed as a ratio in financial analysis. Gearing ratios focus on leverage more than other ratios used in accounting or investment analysis. The underlying principle assumes that some leverage is good, but too much places an organization at risk.

At a fundamental level, gearing can be differentiated from leverage. Leverage refers to the amount of debt incurred to invest and obtain a higher return, while gearing compares debt with total equity—or an expression of the percentage of company funding through borrowing. This difference is found when comparing the debt ratio and the debt-to-equity ratio.

Gearing and leverage are used interchangeably. European entities tend to use the term “gearing” while Americans refer to it as “leverage.”

What Is the Debt-to-Equity Ratio?

The debt-to-equity ratio compares total liabilities to shareholders’ equity. It is one of the most widely and consistently used leverage/gearing ratios, expressing how much suppliers, lenders, and other creditors have committed to the company versus what the shareholders have committed.

Different variations of the debt-to-equity ratio exist, and unofficial standards are used among separate industries. For example, banks often have preset restrictions on the maximum debt-to-equity ratio of borrowers for different types of businesses defined in debt covenants.

A D/E ratio below 1 may be considered relatively safe, whereas values of 2 or higher might be considered risky. For example, A ratio of 1.5 indicates a company has $1.50 of debt for every $1 of equity.

What Gearing Ratios Mean for Investors

Gearing or leverage ratios help investors understand a company’s economic health and if an investment is worthwhile or not. A company with a high gearing ratio generally has a riskier financing structure than a company with a lower gearing ratio. However, regulated entities typically have higher gearing ratios because they can operate with more debt.

Companies in monopolistic situations may operate with higher gearing ratios because their strategic marketing position puts them at a lower risk of default. Industries that use expensive fixed assets typically have higher gearing ratios because these fixed assets are often financed with debt.

Is a High Debt-to-Equity Ratio a Bad Indicator?

Debt-to-equity, like all gearing ratios, reflects a business’ capital structure. A higher ratio is not always a poor indicator, because debt can be a cheaper source of financing and comes with increased tax advantages.

What Affects a Company’s Gearing Ratios?

The size and history of specific companies must be considered when analyzing gearing ratios. Large, well-established companies can push their liabilities to a higher percentage of their balance sheets without raising serious concerns. Companies that do not have long track records of success are much more sensitive to high debt burdens.

What Are Types of Gearing Ratios?

Besides the Debt-to-Equity ratio, other gearing ratios include the times interest earned ratio and the shareholder-equity ratio. The TIE ratio shows how well a company can pay the interest on its debts. The shareholder-equity ratio shows how much of a company’s assets are funded by issuing stock rather than borrowing money.

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The Bottom Line

Debt is inherently risky so investors favor businesses with lower gearing ratios. Gearing ratios include the debt-to-equity ratio. For investors, lower ratios commonly means companies can support their debt and have a decreased probability of bankruptcy in the event of an economic downturn.