There have been many accounting scandals over the years which resulted in more traders showing interest in learning how to analyze a company's financial statements. When companies do declare bankruptcy, it is usually because they cannot pay their debts. So let’s take a look at the importance of corporate debt and go over how an investor can analyze a company’s liquidity.
Economic theory says that the mix of debt and equity in a company’s capital structure is irrelevant, that the value of a firm should be independent of its debt ratio. In the real world, companies and investors have to worry about things like taxes and the risk of default, so a company's capital structure can be relevant to its long-term survival.
Long -term creditors can also put restrictions on the company such as preventing it from taking on additional debt or paying higher dividends. Most public 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. But the greater the proportion of debt to equity on the balance sheet, the higher the business risk.
Since a lot of corporate debt tends to be short-term, there can be a real risk to the company if investors lose confidence in it. It is not unlike a run on a bank, where liabilities (loans) have a longer duration than their assets (deposits). If everyone suddenly wants their money now, the bank will not be able to meet the demand and be forced to close. That is why it is important to look at a company’s debt and liquidity.
Liquidity in the option markets refers to the volume of contracts changing hands in a day. There is lots of liquidity in the options of companies such as IBM and Microsoft, since there are many buyers and sellers. However, liquidity means something very different at the company level. Here we are referring 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. Agencies rate a company’s debt according to the perceived threat of default. Still, crises periodically seem to emerge from almost nowhere to cause the sudden collapse of companies that seemed solid only weeks before. Once investors lose confidence, as companies such as Enron, Qwest and WorldCom learned, liquidity can mean the difference between survival and death. That is why investors should always take a little time to check debt and liquidity ratios before entering any trading position.
Most investors are familiar with the corporate bond market. When a ratings agency such as Moody’s or Standard and Poor’s downgrades a company’s debt, this certainly causes the company’s bond holders some distress, as the value of the bonds will drop. Still, since corporate bonds are primarily long-term debt, this is not usually the source of liquidity problems (unless a large amount just happens to be nearing expiration). No, it is usually a company’s short-term debt that gets them in trouble.
When a company runs into financial problems, their debt rating is usually quickly downgraded. Investors demand a higher premium to lend to the company. If they lose confidence altogether they will simply refuse to lend at any price. If the company does not have liquid assets available, even temporary cash flow problems can quickly become life threatening.
Of course, the banks most companies up in the short term. Before investors will buy commercial paper, they usually require a commercial paper back-up facility with a bank. This gives them a bit more security that they will be paid. However, this facility is not meant to be used, and drawing on it is an admission the company is having severe liquidity problems. This is what happened to Qwest about two years ago.
When Qwest had trouble borrowing in the commercial paper markets, they had to draw down their $4 billion credit line with banks. It was a stop-gap measure that put off a financial reckoning for a few months, but credit agencies responded by cutting the rating on its outstanding bonds to near junk status. $4 billion is a lot of money to come up with in short time. By comparison, their market capitalization was $16.4 billion at the time, they had annual revenue of about $20 billion, and a loss of $4 billion the previous year.
So one of the first ratios an investor should look at is the company’s debt to its total capital. Total capital is all their debt plus equity. This ratio should be compared with what is normal in their industry and not simply against all other businesses.
The next thing to look at is a company's ability to meet its debt payments. This is measured by a ratio called “times interest earned”. Times interest earned is a company’s earnings divided by their total interest cost. For the earnings number you could choose to use EBIT (earnings before interest and taxes), or the more aggressive EBITDA (which adds back the non-cash costs of depreciation and amortization).
Even if you are not looking at looking at a company’s financials, other investors certainly are. Below is a table I put together that have some of these key numbers and compares Qwest at that time of their financial problems with the other “baby bells” of the time: SBC Communications (Whose symbol was SBC, and is now AT&T), Verizon (Symbol: VZ), and Bell South (Symbol: BLS). Numbers are in billions of dollars.
Company Total Debt Equity Earnings Times Interest Earned
Q 24.8 6.1 -4.0 -0.67
SBC 26.1 32.3 7.2 5.51
VZ 63.9 31.6 0.6 1.98
BLS 20.1 18.6 2.5 3.15
You can see that Qwest at the time had a substantially higher amount of debt relative to their equity. Their times interest earned number looks particularly bad. Investors clearly recognized that Qwest was a substantially more risky investment with a worse financial outlook compared to its peers. Below is a price chart that compares the financial performance of these four companies for the period March 2001- March 2002:
Investors should also take a look at a company's current ratio and the quick ratio. The current ratio is a measurement of cash resources relative to the short-term level of obligations. It is calculated by dividing all current assets by all current liabilities. Current assets include cash and equivalents, marketable securities, accounts receivables, inventory, and prepaid expenses. Current liabilities include all debt due within a year.
This ratio gives you a sense of a company's ability to meet all 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 (Qwest had a current ratio of 0.6).
The quick ratio is a little more conservative measure of liquidity than the current ratio, since it subtracts inventory from current assets. A healthy company should have a quick ratio of at least 1.0 (Qwest had a quick ratio of 0.5). An even more conservative ratio would be the cash ratio, which is the sum of cash and marketable securities divided by current liabilities, but I would rarely loof at this myself. It requires more work to dig out and calculate, while the other ratios are easily found on any decent financial website.
As you can see, both ratios for Qwest were well under 1. Does this mean you should look for this in other companies and immediately enter short positions (like buying puts) on them? Not Necessarily. All the “Baby Bells” (Bell South, SBC Communications, and Verizon) had similar current and quick ratios of between 0.4 and 0.7. The key in this industry is investor confidence, and these companies could go on like this indefinitely as long as investors retain their confidence in them.
What does this mean over the long-term investors? First, you would have made more money over the past five years choosing one of the other baby bells. The chart below compares the growth of $10,000 during the prior time period for the four companies:
The other thing you will notice is that Quest has exhibited much more price volatility than its peers, and obviously got caught up in the tech and telecom bubble more than any of its peers. If you got out at the height of the bubble you obviously would have made more. But if, like most investors, you continued to hold on through the collapse of that bubble you would have lost about two-thirds of your original investment.
Just as no option strategy works in every market and situation, there is no one financial number or ratio that can give you all the information you need. Hopefully this article has convinced you the importance of at least looking a company’s debt and liquidity situation before you consider entering any position.