The Credit Markets and Company Liquidity
Jim Graham
Troubles in the credit markets have been the main theme of the financial news lately. What began as difficulties with sub-prime mortgage loans, and other debt instruments related to them, has spread to other sections of the credit markets. Firms in the finance and banking sectors are having problems, with the dramatic downfall of investment bank Bear Stearns the most recent sign that the problems are not over.
The Federal Reserve has moved aggressively to lower interest rates and taken unprecedented steps to inject additional liquidity into the markets in an attempt to prevent these problems from spilling over into the general economy. In some ways this already failed, since the economy has definitely slowed. Thus far the damage has been confined to financial firms that are directly impacted by problems in the credit markets.
The main mechanism by which these problems can affect the "real" economy is by reducing the amount of credit available to firms. Financial firms have had to write off billions of dollars in investments, and banks have been busy shoring up their balance sheets by getting fresh equity investments. As they try to conserve cash and improve their balance sheets, banks and financial firms then become more reluctant to lend and may also call in some loans to raise cash.
The Financing of a Firm: Debt vs. Equity
Economic theory says that the mix of debt and equity in a company's capital structure is irrelevant and that the value of a firm is independent of its debt ratio. In finance, capital structure refers to the way a company finances its assets through a combination of debt and equity. In the real world, companies and investors have to worry about things like taxes and the default, so a company's capital structure is relevant to long-term survival.
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Of course, most companies have at least some debt, and the biggest reason to take on debt is to leverage the equity (much like buying stock on margin). Return on equity is very important to investors, and borrowing allows the firm to increase the return on equity. But the greater the proportion of debt to equity on the balance sheet, the higher the risk.
There are different kinds of debt: short-term paper, bank loans, corporate bonds, and hybrid securities (convertible bonds, preferred stock, etc.). So companies not only have to decide what mix of debt and equity to use, they also have to think about how to structure their debt. Corporate bonds and bank loans tend to be longer-term. Long term credit agreements usually put restrictions on the company, such as preventing it from taking on additional debt or paying higher dividends.
Most investors are familiar with bank loans and the corporate bond market. A company's bonds are almost always rated by a ratings agency such as Moody's or Standard and Poor's. Agencies rate a company's debt according to the perceived threat of default. If these agencies downgrade a company's debt, it will cause the company's bond holders some distress, because the value of the bonds will drop. It may also trigger covenants in their bank debt that make them pay a higher interest rate.
There are a number of ways to measure how a company is financed. If a hypothetical firm sells $25 billion in equity and borrows $75 billion, it is 25% equity financed and 75% debt financed. Probably the most popular measure of leverage would be the Debt to Equity ratio, which would be 75/25 = 3 in this case.
The other measure an investor might want to look at is the ratio of a company's debt to its total capital. Total capital is debt plus equity, and this is often called the leverage ratio. Using our same example, dividing its total assets by its debt, it would be 100/25 = 4. Because companies in different industries tend to be financed differently, this ratio should really be compared with industry norms, not simply against all other businesses.
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Crises periodically emerge in the credit markets, sometimes seemingly out of nowhere. During these periods, there is usually a rush by investors to move money into the safest assets such as US Treasuries, and to unload any other assets that are seen as having any risk at all. This can cause the collapse of companies that seemed solid only weeks before.
The collapse of a firm happens if it suddenly finds it is unable to finance its operations. Corporate bonds and bank debt are primarily long-term debt, so this is not usually the source of liquidity problems (unless a large amount just happens to be nearing expiration). Typically it is a company's short-term debt that gets them in trouble, and a lot of corporate debt tends to be short-term.
Financing in the Short Term
It used to be that banks were the primary source of lending, but that changed dramatically over the past three decades. Corporations no longer rely on banks for the bulk of their financing needs. Credit agreements with banks today tend to be used only for long-term investment, buying other companies, and as emergency back-up facilities. For their working capital and short-term cash needs, most companies issue commercial paper.
Commercial paper is a short-term unsecured promissory note. Maturities can range up to 270 days, but most average about 30 days and many are simply rolled over day-by-day. Most companies use commercial paper to raise cash needed for current transactions, and just keep rolling it over when the notes come due.
Because of this, there is a real risk to a company if they cannot roll over that debt. That can happen if investors lose confidence in the company itself, or just because of supply problems in the credit markets. If a company cannot roll over that debt for any reason, and cannot refinance it in another way, the company may even have to declare bankruptcy. It is not unlike a run on a bank, where liabilities (loans) have a longer duration than assets (deposits). If everyone wants their money back now, the bank cannot meet that demand.
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Therefore, the liquidity of a company can be very important. Liquidity refers to whether or not the company has, or can generate, enough cash to keep operating if they had to pay off short-term debt quickly. Banks use liquidity analysis to assess the risk of a company not being able to repay them in the short term, while other investors in the credit markets rely primarily on the ratings agencies to tell them how a company is doing.
When a company runs into problems, their debt rating is usually quickly downgraded. Investors will then demand a higher premium to lend to the company, or if they lose confidence altogether they may simply refuse to lend at any price. Once investors lose confidence in a company, or the credit markets the company uses, liquidity can mean the difference between survival and death. If the company does not have liquid assets available, even a temporary cash flow problem can quickly become life threatening.
Even though the banks are no longer the primary source of short-term lending, they still provide back-up facilities for the short term debt of most companies. That is because investors usually require a commercial paper back-up facility with a bank before they will even buy commercial paper. This gives buyers of commercial paper a bit more security that they will be paid, and the banks get to collect a quarterly fee for providing this reassurance. However, this facility is not meant to be used, and drawing on it is an admission that the company is having severe liquidity problems, and there is always the risk that the bank may cancel these lines of credit for borrowers that seem the most affected.
A company's ability to meet its debt payments is measured by the interest coverage ratio, also called "times interest earned". This is a company's earnings divided by their total interest cost. For earnings, you could use EBIT (earnings before interest and taxes), or the more aggressive EBITDA (which adds back the non-cash costs of depreciation and amortization).
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Other measures of a company's ability to pay its bills are the current ratio and the quick ratio. The current ratio is a measurement of a firm's cash resources relative to their short-term level of obligations. It is calculated by dividing all current assets by all current liabilities. This gives an adequate measure of financial strength in the short term.
Current assets include cash and equivalents, marketable securities, accounts receivables, inventory, and prepaid expenses. Current liabilities include all debt due within a year. So the current ratio tells you if a company can meet all their short-term liabilities with liquid assets, should it need to. A ratio of 1 implies adequate current assets to cover current liabilities, and the higher above 1, the better.
The quick ratio (also called the "acid test") is a more conservative measure of liquidity. It is the current ratio after subtracting inventory from current assets. Again, a healthy company should have a quick ratio of at least 1.0. With the current lending environment, you should probably look for companies that have a current ratio above 1.5 and a quick ratio above 1.0 to ensure the company is able to fund its short-term operating needs.
Conclusion
All of the measures of debt and liquidity measured here can easily be found on any decent financial website. It is always best to know as much as you can about a company before entering any positions. With the current turmoil in the credit markets, looking at the debt and liquidity position of a company can help you avoid nasty surprises.
Does this mean you should look to companies with lower numbers and immediately enter short positions (like buying puts) on them? Not necessarily. The key is investor confidence. Companies with a quick ratio below one can go on rolling their debt indefinitely as long as investors retain their confidence in them. However, if you are entering a bearish position anticipating problems with financing in an industry, it makes sense to choose the companies with the highest debt and least liquidity in that industry.
