Stephen Saap: Being able to borrow to meet continuing operations is getting more difficult as is the ability to borrow to roll over existing debt

One way for companies to allow themselves more financial flexibility was to improve the use of cash flow in order to reduce the need to raise external funds during difficult times, said Stephen Sapp, associate professor at Richard Ivey School of Business.

What should companies do to allow themselves more financial flexibility and capability at a time such as this?

Stock prices and the willingness of banks to lend to other financial institutions and other firms are related to the uncertainty regarding the quality of the loans and leverage at all financial institutions, and the uncertainty about the economy.

The most serious problems, and the ones receiving the majority of attention at present, are related to the quality of loans and other assets at financial institutions. These problems have had a spillover effect, making financial institutions less willing to lend to one another and more interested in conserving their cash rather than lending it to their peers.

Although financial institutions are still key to the functioning of the economy and the ability of businesses to operate, their reputations and ability to provide funds to those in need have been severely diminished recently.

Several years ago, who would have foreseen the problems faced by Lehman Brothers, Merrill Lynch, Bear Stearns, Citibank and many other global players? Who could have guessed that Citibank would lose its AAA-rating and have bonds with yields approaching those of junk bonds?

Although banks around the world continue to lend and investors are still buying corporate bonds, more attention is being paid to quality now than in the past few years.

Because of this situation, firms of all sizes need to manage their cash inflows and outflows more carefully than before. By better using their cash flow, firms are able to reduce their need to raise external funds.

Being able to borrow to meet continuing operations is getting more difficult, as is the ability to borrow to roll over existing debt, so firms must manage their working capital more carefully. The increased level of business uncertainty also results in firms wanting less debt. This means a general decrease in demand by firms to borrow - the firms want less leverage [it decreases their risk of financial distress] and the banks want to lend less.

What should firms do now if they wish to raise finance? Is equity finance still a good option?

To raise capital, firms are continuing to borrow [just less than before] and firms are continuing to issue equity, if publicly listed. I mention the "if publicly listed" part because there are few new initial public offerings coming to the market at present. The seasoned equity offerings (SEOs) from the firms issuing equity are being done quietly, but several investment bankers I have talked to about this have noted that there has continued to be a steady flow of SEOs. Firms are using these to raise money for operations and to take advantage of opportunities as they arise while maintaining flexibility that would not exist with debt during these changing and challenging financial conditions.

We are also seeing an increase in the use of preferred shares. This, as a means of raising capital, had fallen out of favour for years, but recent events have led to an increase in their use to raise funds.

Can mergers and acquisitions support companies when it comes to financing?

Mergers and acquisitions are an interesting topic. Despite the difficult economic times, the volume of mergers and acquisitions has remained high [2008 was one of the largest years ever in terms of global mergers and acquisitions activity]. There are several reasons for this. One of the main ones is that there are some good deals out there at present and partnerships make sense now more than ever.

The only problem is how to raise the funds. Surprisingly, there have not been extensive problems in this regard for transactions among the firms. The same cannot be said for many of the leveraged buy-outs for private equity firms. These have slowed down considerably.

With so many companies under pressure, how can smaller businesses ensure that they can retain their financial flexibility?

Small firms can excel in these markets because they can be more flexible. Though bank credit has become harder to get, smaller firms can more easily adapt and manage their working capital [internally generated funds].

There are still other sources of funds so it is not impossible to get capital, it is just not as easy as it was before and there are more restrictions on the money. As a consequence, careful management of working capital is important to minimise the requirements or need for funds. This is easier for smaller firms. These firms just need to be prepared.

The volatility of all markets around the world has created significant challenges for firms. Despite this volatility, there are still firms issuing equity - they need funds and want to manage their capital structure by decreasing the leverage and thus the constraints imposed by financial institutions on funds - covenants and other requirements if money is required at short notice or if the money cannot be rolled over.

Despite the potential under-valuation from the issuing of equity, firms still find this to be a reasonable way to raise capital and maintain flexibility.

SCMP
1st April, 2009

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