A Study on Firms with Negative Book Value of Equity

• Published date: 01 March 2021
• Author: Haowen Luo,Ian Liu,Niranjan Tripathy
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/irfi.12260

A Study on Firms with Negative

Book Value of Equity

HAOWEN LUO

†

,IAN LIU

‡

AND NIRANJAN TRIPATHY

‡

†

Department of Economics and Finance, Purdue University Fort Wayne,

Fort Wayne, IN and

‡

Department of Finance, Insurance, Real Estate and Law, University of North Texas,

Dallas, TX

ABSTRACT

This paper studies the puzzling negative book equity phenomenon among

US public firms. Our evidence suggests that negative book equity firms

exhibit heterogeneous characteristics. We show that a great portion of these

firms, while operating at excessive capital structure with leverage ratio over

100%, are financially and operationally healthy. These healthy negative book

equity firms increase their debt primarily motived by a need for funds to ful-

fill investment demand. We also find that the off-balance sheet intangible

assets and quality of intangible assets play an important role in determining

the true debt capacity of these firms.

JEL Codes: G30; G31; G32

Accepted: 15 February 2019

I. INTRODUCTION

Afirm’s book value of equity represents the bookvalue of the residual claim for its

common shareholders. Although the limited liability of shareholders guarantees

that shareholders’value will never be negative in the market, the book value of

equity can be negative in financial statements. The existence of negative book

equity firms draws little attention in previous studies mainly because these firms

are, as a group, described as small in terms of market capitalization and are often

excluded from discussions because they are rare (Fama and French 1993). In prac-

tice, these firms also suffer from the stereotype that they are financially distressed

with persistent negative earnings and unlikely to survive for a long period.

Some recent evidence, however, suggests negative book equity firms are not as

rare as they used to be. For example, Jan and Ou (2012)

1

found the frequency of neg-

ative book equity firms increases from 5% (1976–1985) to 15% (1996–2005) among

all Compustat firms, excluding financial and utility firms. Brown et al. (2008) also

conclude that approximately 5% of all listed stocks have had negative book equity

1 In their paper, the negative book value is defined as firms with negative common equity (item

CEQ in Compustat).

© 2019 International Review of Finance Ltd. 2019

International Review of Finance, 21:1, 2021: pp. 145–182

DOI: 10.1111/irfi.12260

since the late 1980s. Moreover, financial distress and negative earnings exp lanations

areunlikelytobetheonlyreasonsfirms’book equities become negative. Some neg-

ative book value firms, such as DirecTV, AutoZone, and Revlon, are financially

healthy withstrong earnings.Many nonearnings-related reasons may be at work.

For example, negative book equity can occur through the accounting treatment

of goodwill, such as goodwill impairment. Additionally, for many promising

new firms in their start-up stages, the lack of financing resources may cause a

temporary short supply in capital, and such firms may report negative book

equity even though they have strong future growth potentials and are not

financially distressed. Even firms who report negative earnings are not always

financially distressed. For instance, we documented 72% of firms with negative

book equity value are loss firms but only 3% of loss firms report a negative book

value of equity (97% of loss firms have a positive book value of equity). These

results imply those loss firms are not the same as firms with negative book

value equity. Taking together, recent evidence suggests our understanding of

negative book equity firms is insufficient and outdated.

The goal of our paper is to better understand firms with negative book equity.

However, unlike previous research simply attributing negative book equity to

negative earnings, we study negative book equity firms from a new perspective

by focusing on their capital structure policies. Our research is motived by the fact

that one common attribute for negative book equity firms is their leverage ratios

are extremely high. By using liabilities over assets as the measure of leverage, we

find this ratio is approximately 1.2 over the sample period and 1.3 after 1980,

compared to 0.48 for positive book equity (PBE) firms. Other measurements of

leverage yield similar results. The debt ratio for negative (positive) book equity

firms is, on average, 83% (20%). The market leverage ratio for negative (positive)

book equity firms is, on average, 53% (18%). The existence of such highly lever-

aged firms is puzzling, especially after several studies have shown the optimal

leverage for firms is relatively low. Hackbarth and Mauer (2012), for example,

find optimal leverage ratios are as low as 12% as a result of debt overhang and

debt dilution in dynamics. Goldstein et al. (2001) obtained an optimal leverage

ratio of 36% by using a dynamic model. More interestingly, a few recent empiri-

cal studies even documented a persistent zero leverage phenomenon (Minton

and Wruck 2001; Devos et al. 2008; Bessler et al. 2010; Strebulaev and Yang

2013). The prevalence among firms to carry zero leverage makes negative book

value firms even more puzzling from a capital structure policy perspective.

Our analysis presentsseveral interesting findings to shed light on puzzling neg-

ative book equity phenomenon. First, in contrary to prior views on negative book

equity firms, we find these firms exhibit rather heterogeneous characteristics:

some of them appear to be much more financially and operationally healthy. Spe-

cifically, we propose a two-way sorting method based on both Tobin’sqand the

Z-score to construct nine portfolios to filter out healthy negative book equity

(HNBE) firms from other negative book equity (ONBE) firms. The results indicate,

among negative book equity firms, approximately 51% of firms, on average, are

firms with positive earnings and low distress risk. Additionally, our findings

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International Review of Finance

indicate negativebook equity phenomenon is not a short-term movement, partic-

ularly for HNBE firms. Over the entire sample period, the mean durationfor HNBE

firms is 4.93 years. Moreover, we show HNBE firms use debt proceeds primarily to

fund investment opportunities rather than to make payouts to shareholders, to

finance their operational losses, or to replace equity for debt.

A possible explanation of the puzzling leverage-increasing activity of these

HNBE firms is their true debt capacities are underestimated. We find strong evi-

dence to support this hypothesis. Specifically, we find intangible assets, such as

number of patents per year, not reflected by the balance sheet, increase the

probability of a firm becoming an HNBE firm. We also find the interaction

between the characteristics of intangible assets plays a critical role in the exis-

tence of HNBE firms. For example, firms with more liquid and high-quality

intangible assets are more similar to become HNBE firms. Overall, our evidence

suggests the extreme capital structure of HNBE firms is less surprising after the

value of off-balance sheet assets is considered.

Our study shares the same theme with Jan and Ou (2012), who also focus on

negative book equity firms. However, our paper is different from theirs in several

important ways. First, in their study, negative book equity firms are homogeneous

and treatedas one group. In contrast,we investigate the heterogeneouscharacteris-

tics among negative book equity firms and show a great portion of these firms pre-

sent distinctive attributes against traditional views on negative book equity firms.

Second, similar to previous findings, their study attributes negative book equity to

negative earnings, which are caused by increased expenditures. However, in our

paper, we propose a new, not-earnings-based explanation to explore the negative

book equity phenomenon from the corporate capital structure perspective. By the

same token, we focus more on the motivations and mechanisms behind capital

structure decisions made by managers, rather than on the stock market reactions

to negative book equity studied extensively in Jan and Ou’s (2012) paper.

This paper extends the literature in the following ways. First, it expands our

understanding of negative book equity firms, a previously ignored but impor-

tant group of corporations. As opposed to previous studies categorizing negative

book equity firms as simply being financially distressed, we find many negative

book equity firms are financially healthy and choose to operate at an extreme

capital structure where liabilities exceed assets. Second, this is the first study, to

the best of our knowledge, to explore capital structure decisions for firms with

negative book equity. Studying the aggressive capital structure behavior by

HNBE firms is important for a better understanding of capital structure deci-

sions in general. Our findings shed lights on the economic mechanisms

prompting firms to become highly leveraged and to remain financially healthy.

II. AN OVERVIEW OF SAMPLE SIZE AND DISTRIBUTIONS

In this paper, we are interested in capital structure decisions by managers, and

negative book equity reflects the consequence of aggressive capital structure

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Myth of Negative Book Equity Firms