In our last email on banking we discussed the need for a reasonable debt to equity ratio when looking for a loan.
While we focused on small to mid-sized companies, companies of all sizes run risks when they become too highly leveraged.
A recent Moody’s publication expressed concern that some leading retail companies have developed an unsustainable capital structure.
The companies, however, contend that any problems are at least two-to-three years down the road. The report further states that highly leveraged retailers are facing increased refinancing risk when their debt begins to mature.
The Most Interesting Statistic …
This is a result of high leverage and weak operating performance. Moody’s did not focus on small to mid-sized companies, but larger companies such as, J. Crew, Payless Shoes and Sears Holdings, among others.
The most interesting statistic is that of all the companies referenced, only two were public companies, the rest owned by private equity firms.
While this article is focused on companies in the retail business the same case can be made for highly leverage companies in any industry. It might be appropriate at this point to look at one business definition of “Highly Leveraged.
” A company or other institution with a high level of debt in proportion to its equity. A highly leveraged company carries a great deal of risk and may increase the likelihood of default or insolvency. A highly leveraged company may have to pay higher interest rates on its debt.”
So What Changed?
Many companies have historically had respectable debt to equity ratios and may not have relied on high levels of debt to finance their business.
So what changed?
There are a number of reasons companies take on more debt to finance their business. For example: companies take on more debt to finance an expansion of their business; to finance a new building expansion or an office or warehouse in a new market; to finance an acquisition; as a result of a leveraged buyout by a private equity firm; or sadly, to finance poor performance and financial losses.
In Most Cases …
In most cases, with the exception of financing losses, debt is taken on to finance projects that will result, at least in the mind of management, in future increases in profitability that will more than cover repayment of the loans.
This mindset creates a situation where the company is highly leveraged for a short period of time, and when the projected profits appear as a result of the investment, debt to equity ratios will return to normal!
Let’s go back to the statement that “companies contend that any problems relating to high levels of debt, are at least two-to-three years down the road“.
Dangerous Assumptions …
In many cases, the type of debt these companies have incurred, has deferred principal payment, interest only periods and balloon payments at the end of the loan.
What companies are assuming is that they will achieve their operating plans, the credit markets will be willing to refinance the loans and interest rates will not be substantially higher.
These assumptions are often misguided and dangerous.
We have written several articles on the impact of higher interest rates and the continued impact of regulation in decreasing the availability of credit. All companies go through unpredictable ups and downs. With the recent concerns about the prospect of a “manufacturing recession” in the next one to two years, an assumption of continued profit expansion is a dangerous one to make.
What To Do Now?
What should highly leveraged companies be doing now? Most of the troubled companies we work with became highly leveraged as a result of consistent multi- year losses that resulted in a declining equity base.
This string of losses reduced the company’s equity and made a once reasonable debt level, highly leveraged.
In other situations, companies incur a high level of debt to finance inventory and accounts receivable.
They may have high inventory levels as a result of unsold obsolete inventory. They may have extended customers’ accounts receivable terms beyond their ability to finance the longer payment period.
We Focus On …
In our engagements with highly leveraged troubled companies, we focus on improving operating performance, as well as monetizing assets to reduce debt.
These steps are important to improve equity in a manner that will reduce leverage over a reasonable period of time.
What our experience has shown is if the company does not take action, or obtain outside help to assist with this process, the company’s continued poor debt to equity ratio will jeopardize its future financing capabilities.
This in turn, creates difficulty in continuing operations or a worst case risk of bankruptcy and/or liquidation.
Remember the definition of Highly Leveraged noted earlier? It is imperative that every business owner, CEO or board member understand if their company is “Highly Leveraged” and have a plan to deal with it.
And if need be, ask for help to ensure the plan and execution are achievable. There is absolutely NO room for error when a company is highly leveraged!
