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Stretching Cash Flow in a Restructuring by Maximising Credit Ratings
14 December 2011
By Denis Baker, CEO, Company Watch, www.companywatch.net
Generating, conserving and rationing cash is a key part of most restructuring assignments. Central to this process is persuading nervy suppliers and service providers to continue to trade on terms that avoid putting an unworkable strain on scarce cash resources. Far too many rescues are scuppered by withdrawal of supplier support or demands for ransom credit terms.
Desperation on the debtor side and fear on the creditor side has in the past meant that maintaining manageable credit terms, or indeed any credit at all with suppliers, was often a matter of wheedling, begging and all manner of subtle and unsubtle persuasion. There were always some suppliers who could be blackmailed into joining the lifeboat crew because their downside was so great, but this was hardly a scientific way of determining cash flow.
These days, credit managers have access to a wide variety of credit information, which influences their decisions about credit limits or the recommendations they make to assist in the wider debate with their colleagues on credit risk. The management teams of struggling companies and their professional advisors need to make sure that they have a clear understanding of how that information is assembled and what facts, figures and ratios are fundamental to the assessment of credit risk in the modern risk management world.
Amazingly, there are still credit information services which rely on nothing more than the net worth of a company as a guide to creditworthiness. Then there are various early warning systems, which pick up significantly adverse events like the late filing of accounts, court judgments and formal insolvency filings, providing extremely useful real time data to prompt credit managers to take urgent action to mitigate a potential loss.
At the other end of the spectrum, there are providers who use complex analytics applied to several key aspects of a company’s financial profile, such as asset management, funding source dependence and profitability, not just as individual factors but in combination and set in the context of the country and the sector in which the business operates, as well as its relative size. A system like this also looks at trend data over several years, avoiding the snapshot mentality which can be so misleading in a dynamic, rapidly evolving commercial situation.
One of the great problems with most credit information is that it relies on out of date financial information, usually accounts filed at a public register of some type or advertised through such channels as newspapers. In the UK for example, public domain information can be as much as 21 months out of date, which might be particularly unfortunate for a company going through a restructuring process which has already put it firmly onto an improving trend. One of the more sophisticated systems offers modelling capability to stress test risk profiles and look at all manner of “what if” scenarios.
The availability of this sort of facility is good news, but it places an onus on restructuring professionals who are nursing ailing businesses to channel data on current trading and financial performance to creditors, credit information providers and credit insurers alike to facilitate this forecasting. The risk if they don’t is that these vital stakeholders and their advisors will come to their own conclusions, which will usually be less positive than the view of prospects seen at the debtor. Like cash conservation, improving management information is another key priority in restructuring assignments. The trick is using it to convince credit managers at suppliers as early as possible that progress is being made and that their risk is not only no longer deteriorating, but actually getting better.
Take a hypothetical example, a manufacturing business with annual sales on a long term downward trend, dipping just below €100m in calendar year 2010. Gross margins have fallen away from a pre-recessionary peak of over 20% to a worrying 13%. Some cost cutting has been achieved, but the company has incurred its second successive €5m pre-tax loss in 2010. Net worth has fallen from €26m at the end of 2008 and is now only €15m at year end 2010.
Interim figures to June 2011 showed a further fall in sales, but at an improved gross margin of 15%, no doubt as the result of the hard work of a restructuring professional beavering away behind the scenes. But there is still a pre-tax loss of €1.5m.
Illustrating this in graphic terms, the financial risk profile looks like this:
Source: Company Watch, December 2011
These charts tell the credit managers of suppliers to this business that the financial health rating (H-Score®) has been in the red warning zone since the 2009 results and is still mired at a score of only 13 out of 100. The recipients of this data know that statistically, one in four companies with an H-Score below 25 go into formal insolvency or undergo through a major financial restructuring. In addition, 90% of all companies which file for insolvency have an H-Score below 25. So not the greatest of risk profiles and one bound to impact on the willingness of suppliers to trade and the price and terms on which they are prepared to do so.
Move this scenario on six months and our hypothetical restructuring expert has continued to work his magic and now the picture looks better, if not exactly rosy. Sales have been pushed back up to near 2010 levels, margins have been squeezed up to 17% by swapping marginal or unprofitable activity for more sensibly priced orders and through better procurement, while €2.5m has been cut from operating costs, even after an increase in marketing activity to reverse the fall in revenues. The result is a small post-tax profit of €250k.
The graphs now look subtly different and definitely more encouraging:
Source: Company Watch, December 2011
The turnaround team can now go to the supplier base with some positive news. The H-Score is up to 27, which crucially is out of the warning zone and the trend is upwards. Add in a sensibly cautious forecast for 2012 showing further positive progress and suddenly, the previous pleading for support turns into a sensible commercial negotiation.
This example only looks at trading performance enhancement, but if this was augmented by some re-scheduling of short term debt, maybe the introduction of further equity or any of the legions of other balance sheet tweaks that form part of most restructuring assignments and the picture would improve still further.
But of course, timing is everything in these situations, so let’s hope that the management team and their restructuring advisors were speaking to their suppliers and to the credit information source quite early in 2011, sharing forecasts and nudging their expectations into more positive territory. Leaving these conversations until the middle of 2012 when the 2011 full year results have been published is clearly far too late.
Credit risk management stopped being a guessing game some time ago and is now much more of a science than a dark art. Ultimately, restructuring professionals need to be transparent about the credit risk they are asking their suppliers to take and use current data to negate shortcomings in the debtor’s historic risk profile. Wherever possible, they also need to involve credit insurers and credit data suppliers in the debate.
In these uncertain times of low or no growth, most suppliers would much rather take an informed decision to support and help rehabilitate a business, than walk away from a potential profit source and crystallise a bad debt in the process. But they will need help to come to that conclusion.
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