Posted On Wednesday, Jul 13, 2016
Companies periodically carry elevated financial risks, as the level of debt reaches abnormal levels. While such a situation can arise at any time depending on what risks the company takes, it is frequently the case when an economic boom ends.
When an economy is booming, it creates an illusion that something important is happening and it would be tragic to miss taking important steps in order to participate in such a boom. But usually many miss the plot and the booming opera or drama comes to a tragic end and the so called important steps results in a disaster. This illusion could be faced by an individual or a corporate.
So what are these important steps or rather missteps...
In an economic boom people and corporate routinely spend more than they earn and imagine that this can go on continuously. It is almost like thinking that the debt need not be settled. But this situation is always not favorable and unlike Ronan Keating’s lyrics “If tomorrow never comes”, in the case of debt, “Tomorrow always comes” and the debt has to be repaid. These debt cycles keep happening and are frequently repeated. Benjamin Graham and David Dodd also refer to such situations in the classic Security Analysis “The post boom in 1919 was marked by an enormous expansion of the industrial inventories carried at high price and financed largely by bank loans. The 1920-1921 collapse of commodity prices made these industrial bank loans a major problem. But the depression of the 1930’s had different characteristics. Industrial borrowings in 1929 had been remarkably small, due first to the absence of commodity of inventory speculation and secondly to the huge sales of the stock to provide additional working capital.(Naturally there was expectations, such as, notably, Anaconda copper mining company which owned $ 35,000,000 to the bank at the end of 1929, increased to $70,500,000 three years later.) The large bank borrowings were shown more frequently by the railroads and public utilities there were contracted to pay for property additions or to meet maturing debt to- in the case of some railways- to carry unearned fixed charges.”
So one can safely assume that generally people and corporates become bullish near market peaks and bearish at the bottom. When they become bullish at the peak they load up debt and get caught in a debt trap. The debt trap is essentially a reflection of living beyond means and such companies or persons eventually go bust.
Some illustrative cases when corporate get into such debt traps are:
As the economy booms, they regularly nurse this idea of expanding rapidly. They do this in order to expand their market share or to enter into unrelated areas and expand in the hope of higher profits. A banker or any lender in a booming economy is more than happy to fund such growth. Sometimes instead of expansion, companies may also go in for acquisitions. A smart company would actually expand in a bearish economy as it can then be ready when the economy turns around and booms. Sadly, expanding during a boom can be disastrous when the economy goes into a natural cyclical slowdown. In a slowdown, the new plant built is not fully used, while the interest cost and the debt repayment starts. Depending on the level of debt or the margins that the company earns, the company could face a sudden death or a slow painful debt. While a slowdown hurts when the company has just expanded by borrowing, acquisitions made by borrowings can hurt for a number of reasons. For example; integrating acquisitions could pose a challenge, the synergy benefits of lowering costs due to acquisition may not come through. In such cases the acquisitions become expensive, and the anticipated cash flows do not flow through. Managing debt used for acquisitions without the cash flows from the acquisition results in a severe strain on the company.
The other interesting situation that arises is when the company does not expand its capacity, but is able to meet the market demand from its existing capacity. However, the company is so excited about the demand for its products; it fails to notice the creeping increase in the number of debtor days or levels of inventory. As the sale does not result in cash coming in immediately, the company has to fund the inventories and have cash to run its operations. So instead of debt being used to fund capacity expansion, it is used to fund working capital needs. In such companies, the sales and profit figures look great, but there is no cash generation in the business. All the cash is either blocked in inventory or as amount due from dealers. But when cash is blocked and the sales boom, then it is a phony boom. The demand is an illusion. The resulting profits is not only temporary they are nothing more than next year’s sales disguised as this year’s earnings.
The debt situation also takes interesting turns when long term assets are funded by short term loans. When the time comes to repay the short term loans, the company is forced to borrow at expensive rates to meet its obligation of repaying the short term loans.
Corporates also regularly borrow, under the assumption that they can replace the debt by permanent capital in future. But the collapse of stock markets or the drying up of risk appetitive amount investors does not make this possible. The servicing of the debt then becomes a problem for such companies.
So what happens to these companies?
Like the barbarians that attacked weak empires corporate raiders may take over such weak companies at throwaway pries when they see hope of reviving it. If there are no buyers of the company, then it could face a natural death.
From an investor's perspective, rigorous analysis of the cash flows and balance sheet becomes important. An adventurous investor may take the risk of investing in highly leveraged company but for a conservative investor, avoiding a highly leveraged company is better.
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