Solvency Risk
Despite striking examples like Bear Stearns and Lehman Brothers, businesses do not typically become insolvent overnight. Rather, most businesses that ultimately experience financial difficulties will pass through several transitional stages on the way to insolvency. During the incubation period, one or more serious problems may be developing quietly without being recognized by outsiders or, in some cases, even by management or the board. The aim of long-term solvency analysis is to highlight early on that a business is on the road to financial distress. In this regard, the board, with the aid of an experienced financial advisor, should ensure that an “early warning system” is in place to monitor the key indicators of the company’s performance, with prompt reporting to the board of material variances and their potential consequences. Some of the obvious symptoms of a developing solvency crisis include:
- Declining sales
- Declining gross and operating margins
- Increasing SG&A expense
- Declining net profits and lower return on invested capital
- Overexpansion without adequate financing facilities
- Weakening cash position
- Significant pension underfunding
- Overexpansion in fixed assets
- Excessive funded debt and fixed liabilities
Perhaps even more important than the analysis of long-term solvency risk is the analysis of short-term liquidity risk. Firms must survive in the short-term if they are to survive in the long-term. The global financial crisis of the past 18 months has highlighted the importance and danger of liquidity risk, i.e., the risk that a company’s near-term ability to generate cash will be insufficient to service working capital needs and debt-service obligations. The implosions at Bear Stearns and Lehman Brothers serve as loud warnings that boards need to be attentive to their company’s liquidity needs and risks, and should ensure that management has implemented appropriate stress testing procedures to measure the effects of potential liquidity shocks both from operations and from disruptions in the financial markets. At a minimum, adequate preparation involves establishing a monitoring system, identifying liquidity alternatives and developing contingency plans.
A business entity can have a desirable excess of assets over liabilities and an acceptable earnings record, but still be in dire need of cash. This problem occurs because assets are not liquid enough and the necessary capital is tied up in receivables and inventory. Often such a business is not able to obtain funds to meet maturing and overdue obligations through customary channels. Similarly, a company that is performing well can become undercapitalized as it experiences rapid, unplanned growth. Such growth limits management’s ability to control its capital position, as it may be unable to meet the new levels of demand. Increased growth will heighten inventory and accounts receivable levels, which, in turn, requires additional means of financing either through borrowings or the use of other current assets.
Given that the least expensive source of cash is effective working capital management, in the current environment, cash flow management needs to be a strategic board priority. Poor management of working capital allows for the slow payment of receivables which results in needed cash being left outside the company. Likewise, an undisciplined management of inventory creates unnecessarily high inventory levels (and the additional risk of future obsolescence) and less cash available for other parts of the business. Effective working capital management frees up cash, which can be used to continue to fund ongoing business operations as well as strategic initiatives that will benefit the company when the economy recovers.
To be effective, management and the board need to take early action. Some of the classic warning signs that should trigger close scrutiny of a company’s liquidity include:
- Unusual/inexplicable increases in accounts receivable
- Credit rating downgrades
- Lengthening days payable
- Upward trend in other liabilities
- Negative cash flow from operations
- Deferral of capital expenditures
- Liquidating current assets such as marketable securities
- Inability to make interest payments on public or private debt
- Covenant defaults under long-term credit agreements
Practical Considerations
As a result of the recent recession, it is likely that many companies will continue to operate within or near the boundaries of the zone of insolvency for at least the next 12 months. Accordingly, directors are well advised to review their company’s near-term (12-24 months) business plan, with a specific focus on liquidity and capital requirements and sources. The plan should be “stress tested” against possible downside scenarios and the key assumptions regarding operating cash flow, such as new contracts, new stores, etc. should be debated with management. If appropriate, a revised plan should be developed.
In collaboration with management, the board should assess whether the company’s cash management system is adequately staffed and appropriately controlled. Moreover, the management should identify and evaluate any risks to company’s ability to access (i) short-term liquidity resources, including cash temporarily invested with third parties, availability under revolving credit facilities and normal deferred payment terms for goods and services; and (ii) longer-term capital resources, including free cash flow and capital markets for debt and equity.
The company’s debt and other material agreements should be reviewed from the perspective of the cash flows in the company’s business plan and downside scenarios to evaluate covenant compliance and potential defaults and cross defaults. The management should identify liabilities that the company will not be able to pay as they come due in the ordinary course of business and should consider early renegotiation of covenants and other terms that are likely to be violated.
Importantly, the management and board should develop contingency plans for accessing liquidity and capital beyond traditional sources. Steps that might be considered include (i) drawing on existing borrowing capacity and holding cash, (ii) implementing cost reduction and other cash conservation measures, including suspension of dividends, and (iii) identifying and valuing unencumbered, non-core assets that could be sold to raise cash.
In these times, board deliberations are critical and will be thoroughly scrutinized in future litigation. It is therefore extremely important that the record reflect that directors devoted more time and attention to the company’s affairs than would have been required if the company were financially healthy. Boards should remember to:
- Become informed of all material information reasonably available
- Be fully engaged in the process
- Seek the advice of financial and legal experts
- Establish and maintain an appropriate process and document it accurately
- Document the board’s good faith exercise of its business judgment and its acknowledgment of the fact that the company is experiencing financial difficulties.
Within the zone of insolvency, directors should proceed with the objective of preserving and enhancing the entire corporate enterprise rather than acting for the benefit of any single group.
Distressed situations are extremely complicated and it is important for directors to consult with experts. Under Delaware law, directors are protected in performing their duties in their good faith reliance on the opinions and reports of outside experts. It is not uncommon for management to resist outside assistance without prompting from the board or other stakeholders. The board must make an unemotional assessment of management’s ability to deal with issues facing the company and seek appropriate assistance from outside sources. Timely decisions on these issues can help build credibility with stakeholders.
Richard De Rose is managing director of Houlihan Lokey in New York. Contact him at rderose@HL.com
But can miracles happen for an organization under insolvency to turn around with plans and good policies to rejuvenate an entity back in line with business? I feel that government protection should come into play? I feel like bureaucracies in managing corporate affairs contribute a lot to companies failing to achieve their objectives, deliver on their plans and satisfy the public.
I need to be educated on how this all works.
Thank you.
Richard Gudoi Gid’Agui