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How to spot a company in financial distress – part 1

Emma Rapaport  |  15 Apr 2020Text size  Decrease  Increase  |  
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Borders are slamming shut. Cities are at a standstill. The rapid spread of coronavirus is confining people to their homes and the knock-on effect to businesses, big and small, is staggering.

First it was coronavirus on the high seas, as scenes of holidaymakers trapped in their cabins put the cruise line industry's future in question. Then the airlines grounded their fleets, the lights dimmed for cinemas, retailers flipped their signs to closed, and restaurants looked to takeaway trade to survive. The list of companies temporarily closing their doors is growing every day. The layoffs are here.

The Australian Bureau of Statics estimates that 86 per cent of businesses will be affected by the coronavirus fallout.

Only few businesses have the luxury of turning the crisis into an opportunity. Some admittedly are more inventive than others. Governments are racing to unleash stimulus packages to cushion the impact, but these days we seem to be talking more about hibernation than trade.

As we watch listed companies throw their short-term guidance out the window, we're all left with one question: how long can they last?

MORE IN THIS SERIES:

How to spot a company in financial distress – part 2

How to spot a company in financial distress – part 3

Morningstar equity analyst Gareth James, who spends his days valuing companies in the tech industry, says he is not particularly concerned about his companies going under. For one, tech firms are typically capital light—computers, screens and some office space, computers. Not the types of businesses that require enormous outlays to fund factories, materials and machinery.

Australia’s main securities exchange, ASX Ltd (ASX: ASX), for example, has virtually no net debt on the balance sheet. But even so, James says lenders to capital-intensive companies like utilities and manufacturers will be reluctant to send those companies bankrupt as their first option.

"Lenders want companies to survive and pay back their loans," he says. "If you're a lender sending a company into bankruptcy, you're cutting your nose off to spite your face."

"Lenders’ first option would be to try and work it through. Capitalise the interest and give the company a holiday or renegotiate the terms."

Morningstar head of equity research Peter Warnes says he holds concern for what he deems the “zombie virus” – or companies whose earnings (EBIT) don't cover their net interest expenses.

"These are generally companies residing in the double-B and below segment of the credit rating bell curve," he says. "US corporate debt in this segment totals a not insignificant US$2.5 trillion.

"I suspect the access to the financial ventilator—the credit markets—will be restricted and many will have difficulty breathing.

"Those requiring the most urgent attention are unlikely to get the necessary treatment to survive."

Several industries are reaching out to the government for help. Virgin Airlines (VAH), which stood down thousands of workers and slashed services, has asked for $1.4 billion in a bid to save itself from collapse, while childcare providers were saying that they risked closure before the government offered a lifeline.

In this three-part series, we'll walk through some of the warning signs investors can look for if they're worried about a company’s capacity to keep their doors open through coronavirus. We'll also look at companies that have sturdy financial foundations—balance sheets that can withstand financial shocks.

Part 1: uncovering debt levels and understanding short-term debt
Part 2: understanding long-term debt and other debt metrics
Part 3: companies with rock solid balance sheets

Knowing how to interpret financial statements is critical to understanding how a business is performing as well as figuring out if a stock is good value.

It's worth noting, however, that Morningstar analysts build their assessment of a company's ability to fund its debt into their research methodology and determination of fair value, uncertainty and stewardship ratings, among others.

Determine a company's total debt

James says a good starting point is to identify a company's insolvency risk—or the risk that it can no longer meet its debt obligations when they become due. This can be because the company:

  • Doesn't have enough cash in reserves to pay debt;
  • Has decreasing cash inflows;
  • Has increasing cash outflows; or
  • It can no longer access capital to service its debt

In this scenario, the lender can initiate insolvency proceedings to recover the debt—by for example, liquidating the company's assets. Therefore, James advises investors to hunt down a company's balance sheet and learn about its debt levels.

Companies report how much debt they've got on the balance sheet. The balance sheet, also known as the statement of financial condition, tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets".

Liabilities - There are two main categories of liabilities: current liabilities (due within one year) and noncurrent liabilities (longer-term).

Current liabilities are obligations the firm must pay within a year. For example, your supermarket may have bought and received $1,000 worth of eggs from a local farm but won’t pay for them until next month.
Noncurrent liabilities are the flip side of noncurrent assets. These liabilities represent money the company owes one year or more in the future. For example, the grocer may borrow $1 million from a bank for a new store, which it must pay back in ten years.

Morningstar Premium Subscribers can access the income statements, balance sheets and cash flow statements for hundreds of companies via the stock pages. For example, Ansell Ltd (ASX: ANN) -> Financials Tab -> All Financial Data.

Ansell

Companies with no debt

First, James says investors should determine whether a company has any debt at all. "Some companies don't have debt," he says. 

"The two main reasons are 1. they can't get it or 2. they don't need it. For example, smaller mining companies struggle to secure a loan because lenders see them as too risky. Other companies don't need debt because they generate so much cash and/or they're not capital-intensive businesses – e.g. software companies."

Companies often carry debt on their balance sheets but the figure in isolation only tells part of the story. If a company has $5 million in debt but $10 million in cash, all is well. Therefore, it's better to look at a company's “net debt”—a metric that looks at the overall debt situation by netting the value of a company's liabilities and debts, along with its cash and liquid assets. Put simply, net debt is a company's total debt minus its cash and equivalents.

Companies with debt – consider the severity

For companies that do carry debt on their balance sheet, it's worth considering the severity of the debt.

When is the debt due? – short-term debt
As discussed above, there two main categories of liabilities: short- and long-term debt. If a company has $5 million in debt but it's due in 20 years, the company is arguably in a better position than one that owes $5 million next month and doesn't have the cash on hand.
James advises investors to look through earnings reports to see when the debt matures, but he says current liabilities can be more of a concern, especially if credit markets freeze (i.e. companies can't borrow money).

"The scarier debt is the debt in the current liabilities because that's due in the next year and may need to be refinanced," he says.

"The maturity of the debt is a big consideration because if a company is coming up to having to renew its debt, and it's under stress, then it could face major problems. But if a company has lots of long-term debt locked in, it's going to be able to manage the stress more easily.

"If you think at the moment, people are going to be reluctant to lend money so if you've got companies that face an upcoming debt repayment, that's what you'd want to be nervous about."

For companies with short-term debt on the balance sheet, and no money coming in the door, they have two choices:

  1. Raise more capital through equity or debt issuance, or
  2. Pay the maturity off in cash.

To assess if a company can pay off its debt with cash, we can look at their cash versus the maturity value—or the amount payable to the lender at the end of a debt instrument's holding period. If it is significantly more, the business is probably safe.

If there is less cash than the bond maturity, you'll need to assess if the company can roll over its debt with the bank, issue a bond, or raise capital via the equity market. To do this, we look at the credit rating and the prevailing interest rate for debt at that credit rating. Is the interest rate significantly higher? That might indicate that the company will not be able to raise more money.

In this scenario, James holds special concern for companies with short-term debt on the balance sheet that are yet to turn a profit. These businesses, he says, can run into problems if primary capital markets seize up.

"Let's take a tech stock that has never made a profit and has debt on the books," he says.

"That wasn't an issue before because they could take on debt. The share price was riding high so they could issue new shares and raise more equity capital and use that to repay debt. So, profits weren't as much of an issue.

"But in a crisis, suddenly, primary capital markets effectively close. Investors get scared, and if companies go around asking for money, it can be very difficult to get it. The focus then swings on to the profitability of the company. In the crisis, profit becomes much more important.”

Summary:
• Safest companies have no debt (or no net debt)
• Companies with debt that doesn't mature for a while (long-term debt) are in pretty good shape (covered in part 2)
• Companies that may be in trouble are those with short term maturity debt, in a bad capital market environment, that can't cover their interest payments with current cash flow

 

 

is an editor for Morningstar.com.au

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