Working capital management constitutes the largest share of daily capital structuring. For example, customers generally buy goods on credit. Terms of payment are often 30 or more days depending on the client. This delay can cause the cash crunch for small and growing companies. Profitable businesses have had closure due to poor management of liquidity. So money management is of prime importance for the CFO of such a firm over capital structuring where targets are not clear.
If you are the manager of a company, you will try your best never to let your business run out of cash. From the valuation side this is the usual but not always follows.
Cash over here means necessary money to pay creditors in due time and not cash in the register. Suppose if your company does not meet the daily cash requirements then it has the option of refinancing with new loans over the previous unpaid principle so that it can repay the creditors on time and sustain its credibility.
But what happens when your firm is on the verge of its flexibility. Two possibilities arise otherwise known as self –fuelling prophecies:
- Lenders have your confidence. The company borrows and repays thereby conforming to lender sentiments, and the cycle goes on.
- Lenders are worried about the financial stability and refuse to lend further. So the company goes bankrupt, and lenders see that their beliefs are correct to stop extending credit.
The Bear Stern collapse (an investment banking company) in Mar 2008 justified the self-fuelling prophecy.
So, what can you do to mitigate the second prophecy? There are numerous costlier options.
Matching of asset and liabilities: You can attempt to replicate future incoming cash flows with payments. Say for example you want to buy new machinery for your factory which will take five years to produce output.
So you can obviously take loans where interest payments begin after five years. Matching incoming and outgoing cash flows are easier when you have a predictable cash stream. On the other hand with long-term debt costs accumulate more like liquidity, credit and risk premiums.
Also take into consideration that this method helps more on an overall firm perspective rather than project specific basis.
Pay for being flexible: Banks can be paid for an arbitrary line of credit. But there is a catch as banks might be willing to lend during good times and revoking payment during the gloomy days of business. Even IBM’s 15 billion dollar credit line can be revoked if banks decide so.
Holding investments of liquid nature: You can invest in assets which are relatively safe and can be liquidated with ease. But such assets are only of use to a Treasury Bond Fund. Usual businesses’ requires assets that both risky and hard to sell off. As an example, a half-finished R&D on a high-tech product is hard to liquidate though it is an asset that creates substantial value for business.
Adjusting Capital Structure: You can strategize to give yourself an equity margin which translates to the fact that your future incoming cash flows will cover for your debt. Moreover, the benefits of a better debt ratio are that you will have more cash with you at all times. But they come at a price of more income tax payments for your firm.
On surveying CFO’s we find that they focus a lot on bond ratings and interest ratios. Such vision is good from the adequate liquidity point of view. With higher bond ratings and a huge amount of cash on hand to pay for interest bankruptcy and its costs go out of the window. So is this viewpoint a good sign?
Not always, as there is a flip side to financial flexibility. Having more cash than you can spend is a manager’s dream. But in firms with sluggish growth, all that extra hoard of cash lying around might entice the managers to delve into unnecessary risky ventures. Bankruptcy provides an added stimulus to work harder for both management and employees. Moreover, a company which has significant capital management and a huge financial cushion will never go bankrupt but might be held back by poor management and employees lacking motivation.
Anecdote: How Bond Ratings Doomed Trust Preferred Securities and Created Ecaps
In the year 2005, The American Investment Banking Giant Lehmann Brothers launched a new hybrid debt security ECAPS. In these securities interest payments are taxable (usually perpetual bonds are not so), and they are of long duration and also allow postponing interest payment. Though, they are risky but allow effective interest payment and act like an equity security.
An earlier attempt at forging such a financial instrument had not succeeded (known as Trust Preferred Securities) as Credit Rating Agencies like Moody’s and S&P were not able to assign categories to them. But the ECAPS deal was a success as Moody’s classified it as a hybrid instrument having 75% debt and 25% equity categorizing it to “BASKET D”.
Links of Previous Main Topic:-
- Introduction of corporate finance
- The time value of money and net present value
- Stock and bond valuation annuities and perpetuities
- A first encounter with capital budgeting rules
- Working with time varying rates of return
- Uncertainty default and risk
- Risk and return risk aversion in a perfect market
- Investor choice risk and reward
- The capital asset pricing model
- Market imperfections
- Perfect and efficient markets and classical and behavioral finance
- Capital budgeting applications and pitfalls
- From financial statements to economic cash flows
- Valuation comparables financial ratios
- Corporate claims
- Capital structure and capital budgeting in a perfect market
- Capital structure dynamics firm scale
- Theories of capital structure levels changes and issuing activity
Links of Next Financial Accounting Topics:-
- Debt and debt hybrid offerings
- Seasoned equity offerings
- Initial public offerings ipos
- Raising funds through other claims and means
- The capital market response to issue and dividend announcements
- For value financial structure and corporate strategy analysis
- Capital structure dynamics firm scale
- Capital structure patterns in the united states
- Investment banking and mergers and acquisitions
- Corporate governance
- International finance