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Warning signs of troubled companies: tightening liquidity. (Selected Topic).

Tightening Liquidity

Liquidity is the lifeline of a company. Cash is king.. .as it deteriorates so does the company's ability to fund operations, reinvest and meet capital requirements including payments to the trade. With that said, a thorough understanding of an account's liquid health is essential when making credit decisions. At first glance, it is obviously ideal to see a company with a war chest of cash. However, cash as depicted on the balance sheet is merely a measurement at a specific point in time, which can be significantly lower the next day. Consequently, it is not unusual for a company to manage its balance sheet by short-term payment delays aimed solely at presenting the desired picture. Likewise, merely looking at a company's bottom line can be misleading, especially in light of the recent rash of accounting scandals. Now more than ever, close attention is being paid to Free Cash Flow (FCF), which cuts through the drawbacks of fancy accounting to establish how much cash a company has available for ongoing operatio ns, debt payments/reduction and activities such as expansion and acquisitions.

Free Cash Flow = Cash from operations

+ Interest Expense

- Capital Expenditures/Free Cash Flow

As you can see in the above formula, deteriorating FCF can easily be disguised by reducing capital expenditures. Accordingly, one must not only be wary of a decline in FCF but also a drastic drop in capital expenditures. Reducing expansion-related capital expenditures is typically the first line of action against deteriorating FCF and has little immediate effect on existing operations. Unfortunately, continued deterioration will compel the company to eliminate "necessary" capital expenditures, and will result in shoddy stores and outdated systems, thus accelerating the deterioration of operations. As FCF continues to deteriorate, the company will depend more and more on its credit facility. Therefore, a keen eye for events affecting a company's ability to borrow is a necessity.

In a perfect world, a retailer will only borrow against its credit facility when stock-piling inventory during the period prior to its peak selling season, since this is the time cash flows are the slowest. If the company is FCF positive, it should have the ability to repay some, if not all, the borrowings after the peak selling season. If not, year over year, borrowings will increase and the company's available credit will dwindle. Typically, a retailer's borrowings will be at their highest during the pre-holiday season, and at their lowest during the post-holiday season, as such, comparing credit availability at 9/4/02 to availability at 1/30/03 is almost meaningless. To effectively analyze a company's credit availability, it is important to compare availability at the same time each year vs. the prior year. If available credit declines, there should be a concern as to why. Other than an amendment to the size of the credit facility, there are three reasons why borrowing availability will deteriorate: (1) hi gher borrowings outstanding, (2) assets to support the borrowing base limit the amount the company can borrow, and (3) restrictive covenants. The latter two are often overlooked; however, play an important factor in liquidity. Typically, lending banks secure the loan with the assets of the borrower. Most often in the case of retailers, there is an advance rate applicable to eligible inventory and accounts receivable. In these cases, the banks will impose a borrowing base that will allow the company to borrow up to a percentage of eligible inventory plus a percentage of eligible accounts receivable. Accordingly, credit availability will decline as inventory and accounts receivable decline or the quality of the asset is questionable.

Example: Borrowing Base

Borrowings under Ames Department Stores' DIP facility decreased $13.3 million during the week ended 7/9/02, compared to the previous week. On the surface, it looked positive that the company was able to significantly reduce borrowings. In fact, credit availability eroded $3.7 million during the period because the borrowing base is calculated as a percentage of inventory and accounts receivable, both of which declined over the week.

Frequently, companies will try to hide the results of borrowing base restrictions in their quarterly SEC filings by simply reporting outstanding borrowings. If one is unaware of the existence of a borrowing base, one may simply subtract outstanding borrowings from the total size of the facility and assume that the remainder is available. As you can see in the above Ames example, assumption does not apply.

In addition to imposing a borrowing base, banks could also demand that the borrower comply with a minimum availability covenant as well as certain financial covenants tied to its operating performance and balance sheet.

Example: Minimum Availability Covenant With Fixed Charge Covenant.

Under Ames' pre-petition $750 million revolving credit facility, availability was to be at least $50 million at all times. Additionally, a minimum fixed charge covenant kicked in if availability fell below $75 million. At the time immediately prior to its filing, Ames would have been in violation of the fixed charge covenant. As such, the $750 million facility was effectively reduced to a $675 million facility because, if availability fell below the $75 million threshold, the company would have been in violation of the covenant.

Other restrictive covenants to be aware of are maximum leverage ratio covenants.

Example: Maximum Leverage Ratio Covenant

If a facility's maximum debt/trailing twelve month EBITDA covenant requirement is 7x, and the company currently has $65 million in debt and only $10 million in TTM EBITDA, the ratio would be 6.5x. Assuming TIM EBITDA remains constant, the company's actual availability would be limited to $5 million. This $5 million limit is irrespective of what availability is based upon the borrowing base, amounts outstanding and LCs. Calculated availability could be $6 million, $10 million or any other amount; however, the company could still only borrow $5 million before tripping the covenant.

Upon violation of any covenant, banks will re-evaluate their risk and exposure, while dictating the course of action, which generally involves an amendment to covenants, tighter borrowing base, higher interest rates and/or fees. Further, there is always the potential of a permanent downsizing of the facility and/or an acceleration of repayments, which can be devastating to a company with little access to capital.

If available, and in a pinch, a company will resort to asset sales to generate capital. As such, asset sales should warrant investigation for the underlying cause and effect. The company would then use the proceeds to meet its capital requirements, consequently setting up fewer options in the future. Another, less attractive option, is to close stores and liquidate the inventory to meet capital requirements. This option is less appealing as it rarely provides the return on inventory necessary to make a difference, and often lowers the company's borrowing base, while frequently creating a totally unproductive cash use to support the unexpired lease on the "dark store". This is not to say that whenever a company closes a store it is trying to raise funds to meet capital requirements. Often, such a move is part of a plan to rid itself of underperforming stores, which is not necessarily a warning sign.

In summary, as free cash flows deteriorate, a company's dependency on credit increases. Continued deterioration of operations will begin to deplete available borrowings and eventually violate credit facility covenants, resulting in expensive amendments. When available, a company will turn to asset sales and/or capital markets to meet its cash requirements; however, if it cannot begin to generate positive FCF, it will inevitably run out of time and be left with little choice but a trip to the courts. The quicker an analysis catches the warning signs of tightening liquidity, the quicker one can properly adjust risk.

Dennis Cantalupo is vice president of Creditntell.com. If you have any questions regarding the preceding liquidity warning signs, please feel free to call Dennis at 1.800.789.0123 x 110 or e-mail dennisc@creditntell.com.
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Title Annotation:lack of liquidity
Author:Cantalupo, Dennis
Publication:Business Credit
Geographic Code:1USA
Date:Apr 1, 2003
Words:1326
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