In an event-filled year, 2020, decisions are tougher to make. Risks have increased in leaps and bound. But deals are getting done. Banks are extending loans to corporate borrowers large and small. Trades are being settled. Private-equity funds remain interested in finding the right investments. Fund providers are wrestling with risks and agonizing over the long-term impact of the pandemic on corporate performance.
Performance Counts
Performance and trends dictate creditworthiness and prove insolvency, but they also influence management and board strategy (expansion, growth, downsize, sale of businesses, pursuit of acquisitions, willingness to be acquired, etc.). Is performance predictable? Is it erratic? Is it sustainable?
What is its strategy to use costs to help grow revenues and the business in the long term? Acknowledge for some young firms, some costs are necessary to gear up the business model or prepare for future years of revenue growth.
After having reviewed these trends and metrics, the company's financial health is coming into focus. But we still haven't examined capital structure and must do so.
Of course, check recent trends in familiar liquidity ratios: CA/CL, Cash/CL, and (Cash + AR)/CL. But observe recent trends in cash reserves on the balance sheet. Are reserves generally the same? Are they disappearing and withering? Are they stockpiling? Is cash at low levels and dwindling because the company is paying dividends at high payout rates?
Now after the liquidity evaluation, proceed to long-term debt analysis.
Is the company still piling on debt while losing money?
Is the company generating reasonable earnings, but altering its capital structure to increase returns on capital?
Is the company doing well and has tolerable levels of debt, but is vulnerable in liquidity (because of asset-conversion cycle or its redeploying cash into new ventures)?
This, of course, is not be the comprehensive, exhaustive analysis of a company. Bank risk managers, bank regulators, investment committees, SEC regulators, and fund investors will want to see that and will demand more.
And often, the preliminary assessment leads decision-makers to decide up front whether a deal, loan, trade, or investment is a no-go. Or is it something do-able, but requiring tight structure (covenants, guarantees, management discussion, collateral, principal amortization, etc.)?
Tracy Williams
Should we invest in the equity of a private company? Should we buy the stock of the mature business? Should we lead the syndication of a $1 billion loan? Should we protect ourselves by requiring collateral or imposing an array of financial restrictions (covenants)? Should sell the stock? Should we avoid exposure with the company? Should we not continue to provide working-capital funding?
How do we get comfortable quickly to determine whether the risk of an investment, trade, loan or debt offering is tolerable?
How do we get comfortable quickly to determine whether the risk of an investment, trade, loan or debt offering is tolerable?
How can we, therefore, perform "back of the envelope" analysis of a company when time presses? Or how can we perform a preliminary assessment of the company at least to determine whether it's worth taking follow-up steps to investigate further?
What if you have just 30 minutes to understand the financial story of a company thoroughly (and get a sense of its future financial performance), based on access to a recent annual or interim report (10K, 10Q) or financial summaries prepared by Bloomberg or Yahoo Finance?
What are the "go to" metrics that tell an essential story about historical performance and the company's ability to (a) manage debt obligations and (b) perhaps deliver shareholder value (in the form of promising future cash flow) to equity investors?
Performance Counts
First things first. Check historical performance: Earnings trends and patterns, ROE, NPAT, EBITDA.
Performance and trends dictate creditworthiness and prove insolvency, but they also influence management and board strategy (expansion, growth, downsize, sale of businesses, pursuit of acquisitions, willingness to be acquired, etc.). Is performance predictable? Is it erratic? Is it sustainable?
What has the company done for investors, at least measured by returns on invested capital, if not measured by public stock prices, earnings per share, and price-earnings ratios (if it is indeed a public company)?
The stock market rates a company everyday, although it is whimsical in how it absorbs bits and pieces of new information. The stock price, too, can be subject to exogenous factors (things not much related to the company, but to a macro-economy, industry or operating environment).
ROE (or return on invested or deployed capital) can be calculated easily, swiftly. It shows whether it is meeting expectations of owners, shareholders, but it may also show how it is achieving the returns, if we check the components (ROE = ROS x ATO x ALEV).
Effectively improvements in ROE are a result of (a) how the company manages costs, (b) how the company achieves productivity and revenue growth (given its current infrastructure), and (c) how the company adroitly uses the balance sheet and debt to achieve leverage returns.
For analysis purposes, breaking ROE into components shows how the component is achieving returns or what strategy it is using to reach targets: Cost control? Revenue growth? Business efficiencies? Financial engineering (more leverage)?
Many companies like to report (in financial presentations) returns on "invested capital"--which includes equity and long-term debt combined as "long-term capital." Some companies (typically financial institutions) will report and show trends in returns on "tangible capital" (by excluding intangible assets).
A financial analyst can choose whatever returns ratio works. Sometimes that depends on the industry. The analyst can calculate ratios, of course, without company guidance. But when time is of the essence, choose the ratio that is appropriate to measure how well the company is using the capital long-term investors provide and whether the company is generating the returns they expect.
Companies and bankers also examine the ratio to determine whether the company is achieving results that exceed the "cost of capital"--or cost of funding the balance sheet's long-term assets.
Assessing the adequacy of investment returns (ROE) is important, too, because if targets are not met, management, boards of directors, and large-stake shareholders will consider taking action: New management, new business strategies, spin-offs, business combinations, divestitures, mergers, etc.
Back to the analysis. Dissecting returns on capital hints at the strategies companies have adopted to meet expectations. Is a company-wide cost-control campaign in place? Is the company pushing to increase revenues per facility, per warehouse, per branch, per square foot of retail space?
Increasing leverage, too, can be a strategy. Company financial managers will consider increasing debt to take advantage of low interest rates. They certainly have done that in 2020--from March on. Rates are at historical lows. Is the company achieving favorable returns because of organic factors, because of management's concerted efforts to contain costs, or because of restructuring capital structure on the balance (by taking on more leverage).
Now back to revenues and revenue productivity.
Observe trends over the past five years. And if possible, observe the source of revenues (by product, by subsidiary, by geography, whatever information is immediately available). Are revenues flat, declining, surging, or volatile? Are the factors that explain the trends related to markets, competition, demand (weak or strong) for product, product obsolescence, product growth, pricing, pricing sensitivity or elasticity, or industry influences?
Understand the company's approach to cost control and expense management. Peek at profit margins and cost ratios.
What is its strategy to use costs to help grow revenues and the business in the long term? Acknowledge for some young firms, some costs are necessary to gear up the business model or prepare for future years of revenue growth.
The familiar cost ratios can be checked: EBITDA/Revenues, Operating income/Revenues, CGS/Revenues, Cost-of-sales/Revenues, R&D/Revenues, SGA/Revenues, etc.
Observe trends in ratios, and watch carefully when these ratios increase or when these ratios fluctuate without reason. If they do, they suggest the company is permitting costs to unravel out of control or may not be engaged in an adequate hedging program to reduce costs of raw materials or pricing of commodity-like products.
If time doesn't permit calculations of ratios (because this is, of course, "back of the envelope"), then at least examine Operating income or EBITDA profit margins.
If profit margins are deteriorating, that might suggest the company will need to increase returns on capital in other ways (revenue growth, revenue productivity, and leverage).
Any analysis of costs requires categorization of costs into fixed vs. variable. In downturns such as we observe in 2020, companies with substantial high fixed costs are vulnerable. Revenues will turn downward in a recession, but profits disappear more quickly when fixed costs can't be eliminated.
Throughout these observations and quick computations, begin to draw conclusions. You are letting the numbers and ratios tell the financial story.
Those Precious Cash Flows
Investors and analysts ultimately must assess operating cash flow. That's what pays required interest on debt and shareholder dividends. That's how shareholders and markets achieve "value" (when cash flow increase better than expected) and that's how companies can plan for growth in products and markets.
While at it, use EBITDA (earnings before interest, taxes, depreciation and amortization) momentarily as a proxy for operating cash flows, and observe trends there, too. Accountants will have presented a statement of changes in cash flow, and their derivation of "cash flow from operations" is an even better metric of cash coming in from business activities.
If possible, compute at EBITDA/CapEx and EBITDA/Interest expense. We'll now into the meat-and-potatoes segment of assessing solvency and ability to meet ongoing obligations without having to scramble to find other cash sources or without having to sell fixed assets to raise it.
Can the company at least tend to debt obligations from operating cash? Can it at least handle debt interest and ongoing CapEx requirements smoothly--not to mention meet tax liabilities? If these ratios are both less than 1.0, then there could be ensuing trouble. (Some prefer to look at (EBITDA-CapEX)/Interest expense.)
Ratios less than 1.0 or declining ratios suggest a company needs to resort to secondary ways to handle basic debt and CapEx obligations. Hence, the company might have to take on more debt, borrow under revolving-credit facilities, or use up cash reserves.
After having reviewed these trends and metrics, the company's financial health is coming into focus. But we still haven't examined capital structure and must do so.
Liquidity and All That Debt
Before leaping into a more thorough examination of debt burden and capital structure, take a peek at liquidity: Is there sufficient cash resources to manage through the next 3-6 months?
Of course, check recent trends in familiar liquidity ratios: CA/CL, Cash/CL, and (Cash + AR)/CL. But observe recent trends in cash reserves on the balance sheet. Are reserves generally the same? Are they disappearing and withering? Are they stockpiling? Is cash at low levels and dwindling because the company is paying dividends at high payout rates?
Look for signs and red flags of liquidity risks. A company's long-term prospects may be bright, but is cash on the table or on the way to the treasury to manage a whole host of short-term obligations--those on the horizon within the next quarter?
Now after the liquidity evaluation, proceed to long-term debt analysis.
The initial assessment of ROE and ALEV (asset leverage = asset/equity) gave some indication of how much the company is relying on debt to achieve higher returns and support the funding of long-term assets (infrastructure, capital expenditures, equipment, investments, etc.). On paper, higher leverage implies higher returns on capital. That explains the leveraged finance and leveraged-buy-out industry. Investors can achieve returns beyond 40% just by rearranging an old balance sheet.
Debt is also alluring when interest rates are low. Let's tap into the market now, CFOs will argue, while the going is good, while interest rates (as they are in 2020) are ranging at record lows, and while investors are willing to lend.
But debt must be serviced and paid back. Debt means there must be cash flow to pay those quarterly interest obligations.
Rapid analysis requires us to resort to familiar debt metrics to get a sense of whether, despite performance and cash flows, debt levels are too high, unreasonable or at perilous levels.
In the absence of doing projections (to compute maximum debt capacity) and debt-service coverage (all part of a detailed analysis for a more comprehensive review of the company), check the familiar ratios: Debt/Equity, Debt/Ebitda, Net-debt/Ebitda, Debt/(Ebidta-CapEx).
For complex transactions, analysts, bankers and investors perform in-depth due diligence. They project operating cash flows (from now into perpetuity perhaps), they review all major business sectors in depth, they determine how cash flow will be deployed, they assess how much capital expenditure is necessary to support revenue growth, and they determine how debt will be managed (paid off or refinanced)?
But in the 30-minute window of making a rapid assessment, it's back to familiar debt ratios.
If Debt/Equity is rising quickly (>4?) even as the company is generating earnings, check for stock repurchases and buybacks and question such a buyback strategy.
If Debt/Ebitda is rising quickly (>5?), check for recent borrowings and try to determine the purpose of the borrowings. Check these ratios to see from year to year whether they fluctuate greatly or appear to be stable. Check Debt/Operating cash flow, if time permits.
Compare debt metrics with what is known to be normal for companies in a certain industry or companies in the early or late stages of revenue growth.
If debt is increasing, what is the purpose of the debt? What is it actually funding? Examine cash flows and balance sheets to get quick clues. Is debt funding new investments, fixed assets, or infrastructure?
Is it being used--as it certainly has been in 2020--to build cash reserves to prepare for a tough operating environment? Is it ultimately being used to reward equity investors--stock buy-backs, increases in dividends, e.g.?
And are we comfortable with how the debt has been used or how new debt will be used?
Now it's time to step back and develop themes about what has happened at the company and what will likely happen going forward? Just as important, what could happen if the current downturn scenario worsens?
We can actually draw some conclusions about how swiftly cash reserves can evaporate, what might be the high-probability amount of cash generated from operations, when will the company need to suspend dividends, whether it may need to forestall planned capital expenditures, or whether it will struggle to meet interest payments over the next two quarters?
And we might be able to answer among ourselves:
Is the company still piling on debt while losing money?
Is the company generating reasonable earnings, but altering its capital structure to increase returns on capital?
Is the company doing well and has tolerable levels of debt, but is vulnerable in liquidity (because of asset-conversion cycle or its redeploying cash into new ventures)?
This, of course, is not be the comprehensive, exhaustive analysis of a company. Bank risk managers, bank regulators, investment committees, SEC regulators, and fund investors will want to see that and will demand more.
But preliminary perspectives lead to the more focused, purposeful analysis later and permit analysts to zoom in on what requires further investigation, more answers or more risk-reducing strategies for companies.
And often, the preliminary assessment leads decision-makers to decide up front whether a deal, loan, trade, or investment is a no-go. Or is it something do-able, but requiring tight structure (covenants, guarantees, management discussion, collateral, principal amortization, etc.)?
Tracy Williams
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