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Showing posts with label Cash Flow. Show all posts
Showing posts with label Cash Flow. Show all posts
Monday, March 29, 2010
Wednesday, November 18, 2009
Liquidity Position
There are lots of measures of liquidity. The classics are the current ratio and the quick ratio, but they've fallen out of favor because they don't include cash flow, a critical component of liquidity. Cash burn is too recent to be classic, even though it's been around for a while. But it's limited to on-balance-sheet sources of liquidity.
The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here's a short slide show about it.
The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here's a short slide show about it.
Monday, June 1, 2009
Microsoft's leverage nearly triples!!!
Microsoft borrowed $3.8 billion in the US corporate bond market on May 11, driving its total debt up to $5.8 billion. But there's no need for panic. The company had $36.9 billion worth of cash and investments at the end of March, was producing annualized EBITDA of $23.4 billion, and enjoys triple-A ratings from Moody's and Standard & Poor's.
Cash flow problems?
The question for Microsoft is, why borrow at all? Companies borrow for lots of reasons. One is to make up for weak or erratic cash flows. That doesn't seem to be Microsoft's problem. It's been generating strong free cash flows and stable free cash flow margins.
* Last 12 months as of March 31, 2009
(Free cash flow margin is a concept developed by the Georgia Tech Financial Analysis Lab, a leader in cash flow analytics. For more information go to http://www.mgt.gatech.edu/finlab. We calculate free cash flow somewhat differently from them in this analysis.)
Liquidity Reserves?
Another reason is to build liquidity reserves by borrowing long-term money and keeping the proceeds on hand to meet future needs. But that's typical of lower-grade companies with erratic cash flows or unpredictable cash needs, not a highly rated company with strong cash flow and few financial contingencies, like Microsoft.
War chest?
Another reason to take on more debt is to build a war chest for acquisitions. The likely target for Microsoft is Yahoo, which has a market capitalization of about $21 billion. It might cost Microsoft $25 - $30 billion to acquire Yahoo, but Microsoft doesn't need to borrow money for that. It has $37 billion in cash and investments in reserve.
WACC?
Cost of capital might be the reason. Following the precepts of modern finance, companies like to blend debt with equity in their capital structures to reduce the weighted average cost of capital. Debt is cheaper than equity up to a point, but that point is somewhere around 45% debt capitalization. At only 13.6% debt to capital, Microsoft is a long way from its optimal capital structure.
Market Access?
The last reason for using debt is market access. Companies often borrow to establish themselves in the debt markets. That helps the company's financial managers get familiar with market underwriting standards and practices and gives lenders and investors a chance to become familiar with the company's management, operations, and finances. With this bond issue, Microsoft is now active in the syndicated bank loan, commercial paper, and bond markets.
Microsoft's Motives?
So which reason is it for Microsoft? It's probably a combination of reasons. The prospectus for the bonds says the funds are for "general corporate purposes." We think its most likely for debt market access in anticipation of a major acquisition which might affect liquidity needs.
Risk and Structure
Why does all this matter from a credit risk perspective? Understanding the purpose of the loan is one of the fundamental tenets of credit analysis. For large, investment grade companies the purpose can be very vague ("general corporate purposes"), but for smaller, weaker companies it should be more precise ("working capital financing" or "new equipment purchases").
From a credit structuring perspective, the basic rule is to match the form of the credit to the nature of the need. For a general purpose loan, a revolving credit or a long-term bond would be the best fit (Microsoft's bonds were for 5, 10, and 30 years). For specific needs, the rule of thumb is to match the maturity of the credit to the life of the assets, with short-term lines of credit for working capital and medium-to-long-term loans for fixed assets.
Cash flow problems?
The question for Microsoft is, why borrow at all? Companies borrow for lots of reasons. One is to make up for weak or erratic cash flows. That doesn't seem to be Microsoft's problem. It's been generating strong free cash flows and stable free cash flow margins.
* Last 12 months as of March 31, 2009(Free cash flow margin is a concept developed by the Georgia Tech Financial Analysis Lab, a leader in cash flow analytics. For more information go to http://www.mgt.gatech.edu/finlab. We calculate free cash flow somewhat differently from them in this analysis.)
Liquidity Reserves?
Another reason is to build liquidity reserves by borrowing long-term money and keeping the proceeds on hand to meet future needs. But that's typical of lower-grade companies with erratic cash flows or unpredictable cash needs, not a highly rated company with strong cash flow and few financial contingencies, like Microsoft.
War chest?
Another reason to take on more debt is to build a war chest for acquisitions. The likely target for Microsoft is Yahoo, which has a market capitalization of about $21 billion. It might cost Microsoft $25 - $30 billion to acquire Yahoo, but Microsoft doesn't need to borrow money for that. It has $37 billion in cash and investments in reserve.
WACC?
Cost of capital might be the reason. Following the precepts of modern finance, companies like to blend debt with equity in their capital structures to reduce the weighted average cost of capital. Debt is cheaper than equity up to a point, but that point is somewhere around 45% debt capitalization. At only 13.6% debt to capital, Microsoft is a long way from its optimal capital structure.
Market Access?
The last reason for using debt is market access. Companies often borrow to establish themselves in the debt markets. That helps the company's financial managers get familiar with market underwriting standards and practices and gives lenders and investors a chance to become familiar with the company's management, operations, and finances. With this bond issue, Microsoft is now active in the syndicated bank loan, commercial paper, and bond markets.
Microsoft's Motives?
So which reason is it for Microsoft? It's probably a combination of reasons. The prospectus for the bonds says the funds are for "general corporate purposes." We think its most likely for debt market access in anticipation of a major acquisition which might affect liquidity needs.
Risk and Structure
Why does all this matter from a credit risk perspective? Understanding the purpose of the loan is one of the fundamental tenets of credit analysis. For large, investment grade companies the purpose can be very vague ("general corporate purposes"), but for smaller, weaker companies it should be more precise ("working capital financing" or "new equipment purchases").
From a credit structuring perspective, the basic rule is to match the form of the credit to the nature of the need. For a general purpose loan, a revolving credit or a long-term bond would be the best fit (Microsoft's bonds were for 5, 10, and 30 years). For specific needs, the rule of thumb is to match the maturity of the credit to the life of the assets, with short-term lines of credit for working capital and medium-to-long-term loans for fixed assets.
Thursday, February 12, 2009
Early Warning Signs at Satyam
We mentioned the absence of early warning signs in our earlier post on Satyam – especially the lack of a gap between earnings and cash flow. It turns out there were a few. We can classify them either as behavioral or financial.
Behavioral Warning Signs
Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire - without proper shareholder approval and at an inflated price - two struggling companies controlled by Chairman Ramalinga Raju’s family.
Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.
On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”
This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.
Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.
In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.
If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.
The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.
But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.
Behavioral Warning Signs
Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire - without proper shareholder approval and at an inflated price - two struggling companies controlled by Chairman Ramalinga Raju’s family.
Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.
On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”
This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.
Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.
In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.
If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.
The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.
But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.
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.
Monday, January 5, 2009
Lower Sales Means Higher Cash Flow (Eventually)
As we move further into recession, we often see a pattern in corporate free cash flow (defined here as cash from operating activities minus capital expenditures and dividends). A company's ability to manage cash flow as sales decline is a key determinant of credit quality and an important way to judge management effectiveness.
Here is a typical pattern:
Phase 1: Denial. Sales begin to decline, but management is unclear if it is temporary or the sign of a longer term trend. Optimistic management teams (and those without real-time sales data) do not cut production or purchasing, so inventory balloons in the face of declining sales. Receivable days may also increase as customers struggle with their own cash flow problems. These increases in working capital push free cash flow negative, even as operating income and net income remain positive.
Phase 2: Manage Working Capital. A good management team (with good financial reporting systems) will quickly recognize the cash flow drain and act to bring down working capital. Actions may include cutting production and/or purchases to reduce inventory, aggressively collecting receivables, and perhaps slowing payment on accounts payable. These actions can quickly generate significant amounts of cash, but can also hurt relationships with customers and suppliers.
This chart shows the quarterly financial performance of a capital goods manufacturer in the 2001 recession (shaded). As expected, sales and operating income began to decline as the recession began. However, there was an immediate large drop in free cash flow (caused by a large increase in working capital) followed by an equally large increase in free cash flow (as management slowed production and worked down inventory).
Phase 3: Cut Costs. As management recognizes the true nature of the sales decline, they will begin to cut costs in an attempt to maintain margins. This often means layoffs and pressure on suppliers. This should result in improvements to operating profit and cash flow a few months or quarters into the recession, depending on how quickly management recognizes the problems and moves to cut costs. Today, many companies are in this phase.
Phase 4: Long-Term Restructuring. In some industries, the recession may signal a fundamental shift in demand dynamics - sales may take years to return to pre-recession levels (or may never get there). Companies in these industries must make changes beyond working capital management and short-term layoffs. This long-term restructuring typically involves permanent reductions in capacity, including cuts in capital expenditures and asset sales. On the financial side, the dividend may be reduced or eliminated. These moves are especially painful for management (and often shareholders) who have been focussed on growth. However, if management does not recognize and respond to these trends, the long-term viability of the company is threatened.
The chart above for the capital goods manufacturer shows positive free cash flow (and an improving free cash flow trend) even as operating profit remained negative. The improvement in free cash flow resulted from aggressive cost cuts, asset sales, working capital management, cuts in capital expenditures, and a significant cut in the dividend rate. While painful, these actions by management ensured that the company survived the recession.
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