Liquidity Is Lord Evaluating Imminent Financial Distress
Before exploring the importance of liquidity, a review of the traditional early warning signs is in order. At a broad level, general economic, regulatory or industry trends can point to potential weaknesses in certain sectors. For example, after the Asian crisis during late summer of 1998, commodities markets were destabilized, and companies in the steel, oil and gas, and paper and pulp industries had a difficult time, which might have been predicted through macro-economic analysis. On a company-specific level, weakening operating results in the form of declining sales, shrinking gross margins and increasing bottom-line losses point toward existing or potential problems. Basic financial statement analysis, including trend analysis, ratio analysis and common size analysis, would highlight company-specific issues.
Probably the best-known bankruptcy prediction model is Professor Edward Altman's "Z score."1 A company's Z score is calculated by adding together five balance sheet and performance ratios weighted by established coefficients that account for the relative importance and scaling of the ratios. The precise formula is as follows:
Z score = 1.2 [Net Working Capital/Total Assets] + 1.4 [Retained Earnings/Total Assets] + 3.3 [Earnings Before Interest and Taxes] + .6 [Market Value of Equity/Book Value of Liabilities] + 1.0 [Sales/Total Assets]
Z scores of less than 1.81 indicate a high probability of bankruptcy, while scores between 1.81 and 3.00 are considered borderline. Z scores greater than 3.00 indicate a low probability of bankruptcy.
The Measure of Liquidity
Measures such as Z scores and traditional financial statement ratios are helpful in identifying companies that are experiencing financial problems. However, without further analysis of the one key measure—liquidity—it is difficult to assess the likelihood of imminent financial distress. A company can be a very weak performer in numerous respects—e.g., sales efficiency, profitability and return on assets—but as long as it has access to the funds necessary to continue operating, it is not likely to be a candidate for bankruptcy. Of course, a company cannot continue to lose money forever. Eventually, continued losses, if nothing else, will drain the enterprise of the funds necessary to continue.
Liquidity takes on numerous forms, and an analysis of a company's liquidity is not necessarily as straightforward as might be imagined. The most obvious form of liquidity is cash (including cash equivalents and short-term investments). Everyone is familiar with the phrase "cash is king," but in actuality, a reported cash balance is one of the less useful measures of the true situation. A company with good cash management systems will keep a minimum amount of cash on hand, and any "excess" cash will be used to pay down revolving credit facilities, since interest rates paid on borrowed funds are typically higher than those earned on invested funds. Additionally, cash balances could potentially fluctuate significantly during normal business cycles, and a reported quarter-end balance may not be truly reflective of a company's day-to-day position.
Much more important in the analysis of liquidity is its availability under credit facilities. In assessing availability, one must consider (i) the total size of the facilities, (ii) outstanding borrowings and other uses (e.g., letters of credit), (iii) borrowing base limitations (e.g., a certain percentage of eligible receivables plus a certain percentage of eligible inventories) and (iv) financial covenants. The following example will help to illustrate how each of these factors plays a role.
Fact 1: XYZ has a $50 million revolving credit facility with a consortium of banks.
Assumption: XYZ has $50 million of liquidity.
Fact 2: According to its balance sheet, XYZ has total debt of $22 million (all under the credit facility).
Revised Assumption: XYZ has $28 million of availability under the credit facility ($50 million less $22 million).
Fact 3: XYZ has issued $4 million in letters of credit.
Revised Assumption: XYZ has $24 million of availability under the credit facility ($50 million less the sum of $22 million and $4 million).
Fact 4: Borrowings under the credit facility are limited to 80 percent of eligible accounts receivable and 50 percent of eligible inventory. According to its balance sheet, XYZ has $30 million in accounts receivable and $38 million in inventory.
Revised Assumption: XYZ has $17 million of availability under the credit facility (80 percent of $30 million plus 50 percent of $38 million less the sum of $22 million and $4 million).
Fact 5: $5 million of XYZ's receivables are "ineligible" (e.g., foreign, past due, etc.) and $14 million of XYZ's inventory is "ineligible" (e.g., work in process, aged, etc.)
Revised Assumption: XYZ has $6 million of availability under the credit facility (80 percent of $25 million plus 50 percent of $24 million less the sum of $22 million and $4 million).
Fact 6: XYZ's interest coverage ratio (defined in the credit agreement as "earnings before interest, depreciation and
amortization (EBITDA) divided by interest expense") is 1.27, and the required minimum in the credit agreement is
Revised Assumption: XYZ has no availability under the credit facility.
As can be seen in this example, the analysis of availability under credit facilities can be somewhat complex. Additionally, a proper analysis will be forward-looking (i.e., not only based on existing or published financial data), and various assumptions must therefore be made.
In addition to cash and borrowing availability, companies have numerous other potential sources of liquidity. These include trade credit, working capital and other assets and capital markets, each of which is discussed below.
Trade credit is an important source of liquidity to most companies, particularly those involved with the distribution of goods (e.g., retailers). A company's trade credit is the total amount of credit that its suppliers are willing to extend for the company's purchase of goods and services. Inexperienced analysts often confuse trade credit with the amount of outstanding accounts payable on a company's balance sheet, but in fact, while this represents one component of trade credit, the more important component is what's not on the balance sheet. An accounts payable balance represents the portion of total trade credit that has been used, but available trade credit—the potential source of liquidity—is the difference between total trade credit and outstanding payables.
There are functional limitations on trade credit, as these lines can only be used to purchase specific products from specific vendors. For example, if a vendor provides a company with up to $1 million of credit for 30 days, and the company would only realistically purchase $300,000 of the vendor's goods in a month, the amount of this vendor's trade credit is functionally capped at $300,000. Companies nearing financial distress often find a different problem—the trade credit is lower than the amount necessary for purchases—and such companies must look to other sources of liquidity to fund purchases.
Working capital assets, primarily accounts receivable and inventory, can sometimes be used to generate liquidity. To the extent that a company can reduce its investment in working capital, through measures such as acceleration of the cash collection cycle and employment of inventory management techniques, it can generate additional cash flow.
In assessing working capital as a source of liquidity, it is important to keep two factors in mind. First, companies that are already efficiently managing their working capital are not likely to find liquidity in these assets. On the contrary, the risk exists that if such companies do not maintain their efficiencies, receivable and inventory balances could increase, which would reduce liquidity. Secondly, for companies that maintain credit lines linked to a borrowing base (as in the example above), the liquidity generated by a reduction in working capital assets may be substantially offset by the loss of borrowing availability under the credit lines.
Unencumbered property and equipment, whether used in a company's operations or surplus, also can be considered as a possible source of liquidity. Certainly, any assets that are not being productively employed (typically excess land, buildings or equipment) can be sold to produce cash. Fixed assets that are used in operations, if unencumbered by pre-existing liens, can potentially be used in a financing transaction, such as a sale-leaseback, in order to generate liquidity.
The last major source of liquidity to be discussed, capital markets, is by no means the least important. Over the last several years, record numbers of debt and equity offerings have reached the U.S. market. As a result, companies that would have had difficulty raising debt or equity financing under different market conditions have had an additional source of liquidity available to them. This is why certain companies, such as Internet start-ups, are not likely to find themselves in imminent financial distress, although by most traditional measures they do not appear "healthy."
Cash Flow Forecasts
An evaluation of a company's current liquidity position provides a snapshot view of the situation. This information must be "rolled forward" and compared against a company's needs in order to be properly evaluated. Assume, for example, that after careful analysis it is determined that a company currently has $8.2 million of liquidity. This might sound sufficient, but if the company will actually need $9.2 million to meet its obligations, a serious problem exists beneath the surface. For this reason, a cash flow forecast is the most important tool to judge a company's potential to face imminent financial distress. A sample format of a cash flow statement preferred by this author shows the major components of cash flow without deducting and then adding back non-cash items, as is done in a Generally Accepted Accounting Principles (GAAP) cash flow statement. Table I is an example.
|Period 1||Period 2|
|Beginning cash balance ($ in 000s)||$6,200||$3,200|
|Availability under credit line||2,000||1,000|
|Working capital changes||(500)||1,000|
|Asset sale proceeds||2,000||0|
|L-T debt payments||(1,700)||(1,700)|
|Net cash flow||($3,000)||($4,200)|
|Ending cash balance||$3,200||($1,000)|
|Availability under credit line||1,000||0|
Preparing a cash flow forecast with this level of detail is difficult, if not impossible, without access to non-public financial data from a company. However, a rough cash flow forecast can generally be produced using information about recent historical results and existing financing arrangements that can be found in SEC filings of public companies. The historical data should be assessed in the context of company-specific, industry and general economic trends when being used as a basis for projections.
Fixed Charge Coverage Ratio
Although it has been postulated that no ratio or other calculated measure is as good a barometer to evaluate imminent financial distress as is an assessment of liquidity, there is one ratio that stands above the others for this purpose. A fixed-charge coverage ratio measures a company's cash flow, and is therefore a useful tool to evaluate liquidity. It can be calculated as follows:
EBITDA / Interest + Capital Expenditures + Scheduled Principal Amortization
This ratio incorporates the primary elements of a cash flow statement (see Table I), but on a simplified basis. Note that the only line items not included are working capital changes, taxes and asset sale proceeds. The exclusion of these items does not create much of a problem, since (i) working capital changes are generally difficult to project, and therefore are often assumed to be zero; (ii) companies facing financial distress are likely paying minimal taxes; and (iii) asset sale proceeds, if significant, can be considered outside of the ratio calculation. While there are no hard and fast rules about what is considered to be a healthy fixed-charge coverage ratio, results in the range of 1.0 imply that a company is barely covering its cash needs, results less than 1.0 imply that a company is not meeting its needs, and results above 2.0 generally imply that there is adequate cash flow.
Knowing if a company is likely to file bankruptcy or otherwise face financial distress in the short-term is critical information for many types of people including investors, lenders, suppliers, employees and advisors in the troubled company arena. There is no single test that can accurately predict such an occurrence, but a company's liquidity position is clearly the most important factor in making this assessment. A company may be suffering with poor operating results or a troubled balance sheet, but it will not become truly distressed until it is unable to continue financing its operations. The funds necessary for this purpose may be available from a number of sources besides cash on hand, including credit lines, trade credit, working capital and capital markets; this is why cash may be king, but liquidity is lord.