Personal Finance

Debt stress signs firms ought to keep a keen eye on

debt (3)

Summary

  • The Covid-19 pandemic has brought untold pressure on cash flows for organisations, companies, Small and Micro Enterprises and even at the household level.
  • Hard hit hompanies have taken on more external debt than they would ordinarily require in order to stay afloat.
  • Those companies that have been unable to raise additional cash flow, one-way or the other, have had to shut down or have exchanged hands.

The Covid-19 pandemic has brought untold pressure on cash flows for organisations, companies, Small and Micro Enterprises and even at the household level.

Hard hit hompanies have taken on more external debt than they would ordinarily require in order to stay afloat. Those companies that have been unable to raise additional cash flow, one-way or the other, have had to shut down or have exchanged hands.

Resorting to external debt to fund development projects or operations is not bad, after all. Any fresh graduate of finance will tell you that reasonable debt levels are crucial for fuelling growth and enhancing capital accumulation.

However, increased dependence on debt to finance development or operations comes with a risk and increases vulnerability to debt distress. Indeed, companies that are in a state of over indebtedness are more financially fragile and therefore more vulnerable to external shocks.

While internal debt is often from the owners and is usually interest-free with no or flexible repayment timeframe, external debt is time-bound and comes with a high interest cost, and thus the risk. An appropriate mix of debt and equity is always desirable, with a low ratio indicative of a healthy debt and equity relationship.

However, the challenge has always been striking a proper balance that is sustainable and that does not compromise the company’s ability to meet all its current and future payment obligations without exceptional financial assistance or going into default.

A company exhibiting high debt burden is vulnerable to debt distress. Debt vulnerability applies when a company’s credit rating is low with a high liquidity & solvency risk. The company will also exhibit a surge in external debt uptake and a low interest cover.

A company that has a low-interest coverage ratio has a greater chance of not being able to service its debt, putting it at risk of bankruptcy. In other words, a low-interest coverage ratio means there is a low amount of profits available to meet the interest expense on the debt, hence the imminent difficulty in repaying the debt.

In order to achieve its sustainable growth goals a company should endeavor to keep its debt exposure at levels that it can comfortable manage. This will help the company minimise the risk of default.

Where a company has entered into significant debt exposures, it is recommended for the company to continuously assess its debt vulnerability, carry out debt sustainability analysis, and implement a debt policy framework that sets specific debt thresholds at any stage of growth.

A company should not wait until it starts having trouble in servicing its debt for it to take action. According to IMF website, the debt servicing difficulty can be evidenced by the existence of arrears and ongoing or impending debt restructuring.

It can also be evidenced by indications of a high probability of a future debt distress event when debt and debt service indicators show large near-term breaches, or significant or sustained breach of thresholds.

Instead, companies should take the lead in averting debt distress by looking out for these five main causes of over dependence on debt and taking remedial action in good time, before it gets into the red territory. One of the main sources of debt distress is the twin crises of a balance of payments and debt crisis facing all developing countries.

The unfavourable balance of payments has ensured a net outflow of resources and foreign currency reserves while the debt crisis is crowding out the private sector from accessing cheaper credit. This explains the high foreign exchange rates against major world currencies and high commercial interest rates.

Empirical findings show that external debt in developing economies has more detrimental effects on growth than advanced economies. This is largely due to the high interest rates these debt instruments attract. Further, foreign-

currency denominated debt impact on growth is much more severe than commercial debt denominated in home currency. Companies should look out for debt threats that arise mainly from debt structure and the domination of volatile debt forms, primarily foreign currency denominated bonds.

Further, the prolonged exposure to external shock that severely impaired companies’ ability to generate cash flows is a major cause of cash flow strain during the Covid-19 pandemic. Something that started as a flu rapidly spread to every corner of the world, catching every one flat footed and ill prepared.

Companies that were already operating on the edge have been hit hard the most, and most have collapsed. Borrowed finance or stimulus cheques from governments have mitigated the resultant negative operating cash flows. Some of the companies have borrowed beyond what they can comfortably repay, posing imminent distress threat.

Some companies have now been forced to be innovative, creative and adaptive in order to survive the pandemic. This has left us with a critical lesson to be always prepared for an external shock and have financial capacity to withstand any shock for at least 12 months.