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Nicholas Hyett explains some of the financial jargon which has leapt into the spotlight during the coronavirus crisis.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
The coronavirus outbreak has transformed the way investors look at companies. Growth prospects have taken a back seat and financial resilience is now the order of the day.
The change of focus means you might have noticed some unfamiliar terms cropping up in company reports, fund manager letters and our research. We’ve pulled together a glossary of some of the key terms along with an explanation of why they matter at the moment.
Balance Sheet – Not unfamiliar, but we think the key development of the last few weeks has been the increased scrutiny of company balance sheets.
Balance sheets provide a snap shot of a company’s financial position – showing a company’s assets and liabilities, keeping track of debt as well as cash on hand.
In normal times balance sheets often come second to income statements (which keep track of profits and losses). But with sales collapsing and profits drying up the state of the balance sheet is crucial to determining whether a company can survive the downturn or not.
Liquidity – Liquidity refers to a company’s access to ready cash. Improving access to ready cash has been the priority for most companies in the early stages of the current crisis. That’s meant cutting dividends to keep cash in the business, reducing inventory where possible and drawing down on RCFs.
RCF – An RCF or ‘Revolving Credit Facility’ is the corporate equivalent of a credit card. A bank or group of banks agree to lend up to a certain amount on pre-agreed terms. The company can then choose how much to draw at any one time.
We’ve recently seen a spate of companies drawing down their full allowance in one go. This improves liquidity by increasing the amount of cash on hand. However it also suggests that some businesses are worried banks might tighten lending conditions in response to the current crisis – this would make it harder to borrow more money.
Covenants – Many corporate loans are subject to covenants. They’re conditions lenders attach to a loan to improve the chances they will be repaid.
The most relevant covenants at the moment relate to financial ratios, which aim to prevent the borrower from taking on too much debt. Common conditions include limiting net debt to a certain multiple of profits or a percentage of total asset value. Keep an eye out for, Net debt to EBITDA and net debt to book value.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortisation.
As the name suggested EBITDA is calculated by adding four items back to total profits (or earnings). It’s used as a rough and ready measure of the cash a business generates.
Net debt is calculated by subtracting any available cash the company has from its outstanding debt. Both figures can be found on the company's balance sheet. It's usually compared with a measure of profits to give you an idea of the company's overall financial position.
The collapse in revenues for companies like airlines, retailers and property companies mean profits are suddenly much lower than anyone expected. That means net debt is increasing relative to profits and the chance of breaching covenants is rising. That leads to what’s known as a technical default.
Technical Default – A technical default takes place when a company fails to meet some condition of the loan agreement other than actually repaying the debt. Technical defaults often trigger tough new conditions like higher interest rates or full repayment. That can spark a domino effect through other loans and ultimately lead to bankruptcy.
Given the extraordinary conditions at the moment we’d expect most lenders to grant borrowers a grace period and overlook a temporary breach.
Breaching covenants due to coronavirus fallout shouldn’t be taken as a sign of fundamental weakness. However, it’s never comfortable having your investment resting on someone else’s goodwill. We think companies looking like they’re set for a technical default are best avoided where possible.
Cash flow – Like balance sheets, cash flow is always important, but coming under particular scrutiny at the moment. It measures the proportion of profits that are converted to cold hard cash, and since its cash that pays the bills, when times are tough it’s more important than ever.
Usually we focus on how well new sales convert to cash, but with sales struggling to non-existent for many businesses, we’re now more interested in companies that can keep cash in the business. That means cutting costs, and in some cases that’s been really brutal. Pub company Young & Co furloughed all but 29 employees, but is still likely to see cash leak out the door thanks to non-discretionary spending.
Non-discretionary spending – Kind of does what it says on the tin. Rent, interest on debt and some maintenance spending are costs that simply can’t be avoided.
Companies where non-discretionary spending makes up a large portion of the overall cost base are at a disadvantage in this sort of environment. Those costs will be running down cash reserves and increasing borrowing. The longer the lockdowns continue the greater the damage done.
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