Tuesday, January 20, 2009

Confidence Sensitive Cash Flows: Watch the Trade

The 2007 year-end selling season was not good for the home furnishings retailer "Linens 'n Things." Quarterly sales were up 0.6%, but only because the company opened four new stores. Ignoring the new stores, same store sales were down 1.0% for the quarter and 3.4% for the full year 2007. Even worse, margins were hurt by the "highly promotional environment" and increased marketing spending: quarterly gross margin declined from 36.7% to 33.8% and operating margin (adjusted for non-recurring items) turned negative.

Cash is King: What About Liquidity?
The news was not all bad. For the quarter, adjusted EBITDA was $15.3 million and cash from operating activities was $137.9 million (the large difference between EBITDA and cash flow was the result of the normal year-end sell-through of inventory). Standard liquidity measures looked good at year-end: the current ratio was 1.9x (about the same as the prior year-end) and it had excess availability under its asset-based revolving credit facility of over $300 million.

So what went wrong?
The sales decline accelerated in the first quarter of 2008 and the company responded with an aggressive cost cutting plan. In an effort to conserve cash, the company also began to aggressively manage working capital: it slowed purchases to reduce inventory levels and it began to slow pay some of its vendors. This strategy backfired. By late March, many vendors stopped shipping to Linens 'n Things, citing slow pay and even no pay on outstanding invoices. By mid-April, the company had begun paying cash before delivery to certain key vendors in order to obtain goods.

This cash drain was unsustainable. In the four months from year-end 2007 until its bankruptcy filing on May 2, 2008, the company's use of credit (i.e. revolver borrowings and letters of credit) increased by over $170 million, a burn rate of over $42 million per month.

Lessons Learned
This situation highlights the importance in credit analysis of of looking at a company's confidence sensitive cash flows. This refers to funding (or other cash flow) which depends on a third party's willingness to accept the company's (typically unsecured) credit risk. Examples of confidence sensitive cash flows include short-term borrowings (such as commercial paper), counterparty risk, and (as in the case of Linens 'n Things) trade credit.

1 comment:

Anonymous said...

Working capital can have a huge impact on cash flows butits not always straightforward to analyse. For example, does an increase in the current ratio show increased liquidity or just poorer working capital management? Perhaps, a better approach is to analyse how the stock days, creditor days and debtor days change and why. Also, compare the debtor and creditor days to the normal credit terms that are provided to customers or received by suppliers to see whether this is getting stretched and whether this indicates underlying liquidity problems. One question, what the best way to analyse efficiency of working capital management in seasonal businesses (e.g. where stock levels in September are high because high Xmas sales are expected)?