What does leverage resilience mean for businesses?
What does leverage resilience mean for businesses?
Crises typically happen when we least expect them. And they typically find us unprepared to deal with their repercussions. If a business has inherent weaknesses in its finance structure, this greatly undermines its resilience to overcome the crisis.
One of the most significant inherent imbalances of local companies is the level of, and on many occasions, the unsustainable level of external debt: in the form of bank finance, trade finance from suppliers, overdue employee emoluments and obligations to state authorities.
Unsustainable means that recurring net cash flows (cash inflows minus cash outflows) which are generated year in, year out from the business’s mainstream trading operations (excluding, for example, exceptional items such as one-off contracts which are not expected to be repeated or one-off sales of non-operational assets) cannot support the debt of the business over the reasonable and useful lifetime of the business’s operational/productive asset base.
Let us provide an indicative example to simplify this:
- a transportation company must replace its vehicles fleet to comply with the terms of its contract with the state authorities
- the contact provides that the fleet must be fully replaced over an average period of ten years
- the replacement cost of the entire fleet is budgeted at around €10 million
- the company has a 20% cash equity to contribute towards the acquisition of the new fleet, the remaining amount, i.e. €8 million, must be obtained through bank finance
- the company’s annual recurring cash flows have been around €800.000 over the past five years and are expected to continue like this in the future
- if we allow for other annually recurring payments (e.g. taxes, normal capital expenditure replacements etc.), the average annual cash available for debt servicing comes out at €700.000
- this debt servicing capacity would support a maximum loan amount (including any existing loan amounts on the books of the company) of around €5,8 million over a ten-year period (at an indicative interest rate of 3,5% per annum), therefore the €8 million debt requirement would appear to be unsustainable over the useful time of the investment in this situation
- the company would have to finance the gap by an additional cash equity contribution, or other sources, to align its cash generation capacity with its debt servicing capacity.
Now, imagine what may happen if the above indicative company somehow has a debt level (existing and/or new debt) which is above its maximum debt capacity threshold (€5,8 million in our theoretical example):
i. the company will not be in a position to generate sufficient cash from its operations to cover its scheduled loan commitments and may also have to postpone and/or delay other payments (payroll, trade creditors, taxes, social security contributions etc.)
ii. even if the company’s debt is, for whatever reason, structured on a prolonged duration which does not match the useful economic life of its operational assets, the company may be able to service its debt and other obligations, albeit very tightly. However, what is even more important, when the time comes to replace the fleet in order to continue its operations, this may prove to be very difficult, or not possible at all, as there will be no equity cash reserves available and there will also be residual debt relating to the old fleet which will have to be refinanced on top of the new debt required to fund the acquisition of the new fleet
iii. every new crisis will create havoc with the company’s affairs. Crises will continue to happen when we least expect them to happen. And they may turn a business’s operations upside down. And its financial situation: A reduction in the cash generating ability of a business will have severe consequences on its debt servicing capacity; particularly, in the event that the business is already over-leveraged.
The cycle is well known. Over-leverage, a tight repayment ability (affecting debt commitments, state and other obligations, payroll, trade creditors), a crisis which brings about a complete inability to cover obligations, a business on the brink of insolvency, giving rise to a chain effect of loss of employment, trade credit losses, bank losses and the like.
Leverage resilience implies that a business actively manages its capital and debt structure. It means actively managing the maximum debt capacity which can be comfortably supported by the operational cash generating ability of the company. It means having adequate margins of safety to deal with any unexpected crisis. And it means doing all these before the next crisis reminds us that the business is over-leveraged. Leverage resilience means business viability resilience.
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