We welcome your comments and questions. Here’s a question from one of our readers:
“I frequently come across credits that have a substantial amount of non-cash interestexpense related to hybrid financial instruments.Specifically, the one I have in mind has subordinated mezzanine financing with warrants attached. Embedded in the company’s interest expense is “change in fair value of warrant liability” and “amortization of discount and issuance costs on notes payable”.
In a few of your recent articles (Comments on Credit and RMA) there is some mention of this kind of debt in relation to subordination agreements etc., but I cannot find a good explanation of how to calculate debt service coverage ratios on firms that have these kinds of instruments.
We frequently syndicate our transactions with other traditional commercial banks and in their analysis I’m finding that they don’t exclude non-cash interest expense like this out of their debt service calculations. Some of the banks are more sophisticated than others, but I get the feeling that a lot of them don’t frequently deal with companies like this.
Can you provide any clarity on how one should debt service in a company like this? I can see cases for both excluding and including the expense, but would really like to get your perspective and see if there is something I’m missing.”
Here’s our response:
The two non-cash items that we see most often included in interest expense on a company’s income statement are:
1) Amortization of discount and issuance costs (sometimes called deferred or capitalized financing fees) – very common, but typically very small
2) Accrued and capitalized interest on zero coupon debt or “payment in kind” (or “PIK”) debt – not very common, but sometimes used by higher risk companies
Mezzanine debt is typically used by high-risk, middle market and smaller companies. The total return expected by mezzanine investors is in the mid to high teens. Since borrowers typically can’t afford to pay that much cash interest, mezzanine debt includes other non-cash compensation, including original issue discount (”OID”), PIK interest, and equity warrants. The cost of these items (cash or not) must be included in interest expense in each year. They typically are not broken out on the income statement, but should be detailed in the footnotes.
Now to your question. Non-investment grade and middle-market borrowers typically have a coverage covenant in their bank debt. It may be:
EBITDA coverage: EBITDA / Interest
Debt Service Coverage: EBITDA / (Interest + Scheduled Principal Payments)
Most often, the interest part of this formula is interest expense, right off of the income statement (i.e. including any non-cash interest amounts). However, as with any type of ratio analysis, covenant formulas should be adjusted to fit the unique characteristics of each borrower. For example, retailers with lots of rent expense typically use EBITDAR Coverage (i.e. EBITDAR / Interest + Rent) instead of EBITDA Coverage.
If a company has a lot of non-cash interest, we recommend (and often see) the coverage ratios adjusted to include only cash interest expense (i.e. excluding amortization of issuance costs, capitalized interest, etc.). Here’s why: we see coverage as a measure of liquidity – will the company have enough cash to pay its short-term financial obligations? As such, the closer you can get to cash measures, the better.
Of course, EBITDA isn’t really a cash measure, but that’s a topic for another day …
The Wall Street Journal reported yesterday that Borders Group Inc. was halting payments to some suppliers, and that one publisher had stopped shipping books to Borders. The end is near. As we discussed in an earlier post, if trade creditors lose faith in a company, bankruptcy is almost unavoidable. The term we use is “confidence sensitive cash flows,” which includes, in addition to trade credit, short term borrowings like commercial paper (think Lehman Brothers) and counterparty credit (think Bear Stearns). Once one supplier stops shipping, they all will stop.
Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer). This is another classic early warning sign. Let the countdown begin …
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy- Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
Back in July, we discussed how much progress BP seemed to be making with safety (See “BP’s Safety Warning Signs,” July 11). From 2005 through 2009, the company went from the worst record among the majors to about the best in terms of injuries, deaths, and spills. But, of course, those measures didn’t capture the grave risks hidden below the surface at BP (See “Why, Tony, why?” August 8).
The Macondo well disaster in April 2010 was the shocking result, but since then BP has stopped the leak and made a lot of progress cleaning up the damage, paying claims, and strengthening its finances. Between the end of December 2009 and June 2010, it built up reserves of cash and un-borrowed revolving credits from $13.3 billion to $24.3 billion. From the first half of 2009 to the first half of 2010, it cut capital spending and dividends from $15.3 billion to $11.2 billion.
And it improved cash flow from operating activities from $12.3 billion to $14.4 billion, in spite of $12.5 billion in payments for the Gulf of Mexico oil spill. We don’t question BP’s gains in liquidity or its cash savings from capital spending and dividend cuts. But we think the reported improvement in cash flow from operations is misleading.
For BP, a big source of cash in the first half of 2010 was a $10.3 billion increase in “trade and other payables.” Some $8.3 billion of that is related to the oil spill, but that means $2.0 billion probably is from an increase trade payables. Almost all of BP’s operating cash flow gains were from delaying payments to suppliers, and that’s not a sustainable source of cash.
Once again, the progress in a key measure at BP is more apparent than real. We think the lesson for risk analysts is, as always, not to take things at face value. The trend may seem to be improving, but unless you understand what’s driving the trend you can never really be sure.
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.
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.
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.
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.
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.
Specifically, the one I have in mind has subordinated mezzanine financing with warrants attached. Embedded in the company’s interest expense is “change in fair value of warrant liability” and “amortization of discount and issuance costs on notes payable”.
The Wall Street Journal 
