Money for Nothing
Although we have written about this issue in some of our past blogs, we felt that the topic should be surfaced again as we believe the credit climate is about to change in the foreseeable future.
The credit markets over the past several year have been great for borrowers for a number of reasons. The obvious ones are that: Interest rates are at an all-time low; too much money chasing too few deals; minimal or “No” covenant loans. Most new loan agreements are covenant light due to competition.
The Acquisition Of Ann Taylor …
A recent news story announcing the acquisition of Ann Taylor, a women’s apparel retailer typifies the above. Ascena Retail Group announced they were purchasing Ann Taylor for $2.2 Billion and will finance the acquisition through bank debt. There is no question that acquisitions utilizing a higher degree of debt have been on the increase over the past few years. This will become highly problematic for those companies in the near future, particularly for those acquisitions that are financed with variable interest debt.
The Good Times Will Not …
We believe and have been advising our clients that the good times will not last forever. In fact there have been recent signs that interest rates have already started to increase. For example the 10 year bond yields bottomed out at 1.67% in late January of this year, have now been consistently above 2 % since late April and recently hit a high of 2.3%. While long term rates typically move from day to day, the trend for the past month has certainly reflect a significant increase. This was confirmed in a recent article featured on CNBC with the by-line of “And the rise in yield to a 6-month high is giving investors a little bit of a scare”.
It’s Time For Every Company To Start To …
The graph at the beginning of this blog, prepared by Pitchbook, in 2014 reflects the increase in median debt by middle market companies and is eye opening.
The median balance sheet debt to total capitalization has spiked from 50% in 2009 to 71% in 2014.
The Impact On Compliance Covenants …
Management, as well as their Board of Directors, should be focused on a number of factors to assess the risk of debt level that currently exists on their balance sheets. Debt should be segmented between fixed rate and variable rate debt. As interest rates increase, the level of debt service will increase as well.
The impact for each 1% increase in interest rate on variable debt impacts not only the earnings of the company, but also has an impact on compliance with lender covenants. Remember that most fixed charge covenants include interest, so with higher interest rates, achieving debt covenants may be more difficult. There may be other covenants that are impacted, so all covenants need to be tested for sensitivity to interest rate increases.
If the company has a high level of variable rate debt, that has been used to finance capital expenditures, or acquisitions, consider restructuring the debt to a longer term fixed rate debt. Take advantage of the current credit climate to restructure the debt before credit starts to tighten and terms are less favorable.
Do You Have “Covenant Light” Debt?
One of the consequences of rising interest rates is that banks start to tighten credit and have less favorable terms. Low interest rates loans with “covenant light” terms, will be scrutinized more carefully by credit departments, particularly if the company is not achieving its financial plan.
Make sure the financial plan and borrowing forecast is as conservative as possible. We always advise our clients to have two plans, a conservative plan for the bank and a realistic plan for the board of directors. Ensure you have built in any potential downside into the bank plan to make sure it is achievable. It is always easier to explain why you have exceeded plan that to explain why you have missed it.
Unlock Internally Generated Capital …
Companies should always look for ways to unlock internally generated capital. In periods of rising interest rates and tightening credit, it is essential. Look for ways to improve inventory turnover by challenging the status quo. Understand what your industry average inventory turnover ratio is and look for ways to set an inventory turnover goal that exceeds it.
You should also review the inventory aging report. Cleaning up old inventory may cost a few points in gross margin, however it could potentially free up a significant level of cash. In our experience we typically find that 10-20% of inventory is obsolete or slow moving. Minimizing old or slow moving inventory is a great opportunity to improve working capital and lower interest rate costs. We have found ways, with our client companies, to significantly improve inventory turnover by thinking outside of the box and challenging the accepted norms.
Another way to unlock internally generated capital is to review your expense structure. Many companies get locked into a fixed cost expense structure and as a result have little room to cut, when sales do not meet expectations. By converting expenses from fixed to variable costs, there typically is an immediate benefit by reducing expenses and providing a buffer in case of a sales decline. The power of incremental variable expense translates to a higher return on sales as sales increase.
This Produced Immediate Benefits …
An example of this type of change was demonstrated with one of our clients that had a sales force with 65% fixed salary and benefit cost and 35% variable commissions. We developed a plan that changed the fixed salary and benefit costs ratio to 50% resulting in 50% of the costs being variable. This produced immediate benefits and gave the higher performing sales people the opportunity to increase their compensation beyond the previous level.
Now Is The Time …
Now is the time to proactively reevaluate your balance sheets. The days of “Money for Nothing” will be coming to an end soon.
You and your company must be prepared to capitalize on the opportunity that exists now