Financial prudence is therefore essential in order to manage debt effectively in the face of growing credit demand.
Financial prudence is therefore essential in order to manage debt effectively in the face of growing credit demand.
Debt, being a long-term commitment, exposes companies to long-term debt related stress including fear of default, lack of cash flow to meet the repayment obligation on time, and cost of debt among others.
A company experiences over indebtedness when it fails to manage the debt appropriately.
Debt stress to a company is similar to debt stress at the household level. It means a company does not have cash to meet its regular debt repayment obligations.
This could be due to a variety of reasons, ranging from delays in collections to the company being over indebted. Also the cash flows may not be sufficient to service the high level of debt burden. It could also be due to business downward cycle.
Financial prudence is therefore essential in order to manage debt effectively in the face of growing credit demand.
Debt, being a long-term commitment, exposes companies to long-term debt related stress including fear of default, lack of cash flow to meet the repayment obligation on time, and cost of debt among others.
A company experiences over indebtedness when it fails to manage the debt appropriately.
There will always be plentiful of signs that a company is experiencing debt distress.
Companies can, therefore, perform stress tests and develop frameworks to detect at an early stage, symptom of debt distress and quickly implement remedial actions. Some of the early warning stress signals for detecting debt distress include:
Higher Debt to Equity Ratio
For companies, the quickest test to calculating a company’s debt carrying capacity is the debt to equity ratio, also known as gearing ratio in technical jargon. The debt to equity ratio is a solvency ratio that shows the relation between the portion of assets financed by lenders and shareholders.
Using figures obtained through financial statements, the ratio is used to evaluate a company’s financial leverage. For a country, its equivalent is the Gross Domestic Product (GDP) to debt ratio.
Whereas a country like the USA is projected to have debt to GDP of 115 percent by end of 2021, commercial companies can ill afford the luxury of having more debt than the value of the company. To do that is indeed suicidal and can be seen as an express ticket to bankruptcy.
This is why it is so crucial for debt policies to not only define the type, form and structure of debt instruments, but the policy should also set the maximum debt-to-equity ratio that ensures the health and future of the company is not compromised by excessive debt burden.
A 50:50 debt to equity ratio shows a balance between debt and equity. A more financially stable company usually has a lower debt to equity ratio. However, a lower ratio may not always be optimal for performance or profitability. It could be indicative that the company is not taking advantage of the increased productivity that financial leverage may bring.
A higher ratio indicates that there is more usage of debt than shareholder financing. When a company is not performing at optimal levels, it will resort to aggressive debt financing to obtain enough cash to fulfill its debt obligations.
At this point, it is more prudent to look at equity injection to rebalance the debt equity ratio.
MISUSE OF WORKING CAPITAL TO INVEST IN LONG TERM ASSETS
The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
A company's working capital is made up of its current assets minus its current liabilities. Current assets include anything that can be easily converted into cash within 12 months. Some current assets include cash, accounts receivable, inventory, and short-term investments.
Current liabilities are any obligations due within the following 12 months. These include operating expenses and short-term debt repayments.
To have positive net working capital, a company must finance part of its working capital on a long-term basis. Permanent working capital refers to the minimum amount of investment, which should always be there in the fixed or minimum current assets like inventory, accounts receivable, or cash balance etc., in order to carry out business smoothly.
A company can be pushed into financial distress when the permanent working capital portion is raided to finance long-term investments. Using working capital to finance long-term investments depletes the long-term portion of working capital leading to defaults on debt obligations, cash shortages, stock outs and undue pressure on receivables.
Using expensive debt such as overdraft and online money lenders
When a company resorts to using expensive debt it indicates the company has been locked out of cheaper sources of finance such as trade creditors and term loans.
An overdraft is an extension of credit from a lending institution that is granted when an account balance reaches zero. An overdraft means that the bank allows customers to borrow a set amount of money on a revolving basis and is re-negotiated annually. There is interest on the loan, and there is a fee per overdraft arrangement.
Overdrafts rates are always more expensive than term loans as interest is calculated daily on overdrawn balance, more like compound interest calculations.
One published commercial bank overdraft rate shows overdraft interest at CBR 13 percent plus 4 with negotiation fees of 3 percent effectively topping 20 percent annualised rate while term loans are in the region of 12 - 15 percent. Online moneylenders charge annualised interest rates of up to 150 percent or more.
CURRENT LIABILITIES MORE THAN CURRENT ASSETS
Current liabilities will be more than current assets when the quality of assets is low or where assets have been depleted in an environment of sustained losses.
There will be high impairment of assets, high provision of bad debts and high stock obsolescence. In turn, the accounts receivable and stock turnovers will be low as collections and sales are impacted by the low quality of assets.
When current liabilities are more than current assets then the company is not able to meet its obligations as they fall due. More borrowings only makes the situation worse. This may call for injection of cash by owners or disposal of assets to generate cash flow.
Negative net assets
Net assets are the value of a company's assets minus its liabilities. Net assets are what a company owns outright, minus what it owes. Net assets equal the company assets minus liabilities.
Net assets provide a rough guide for the value of company resources. Typically, the higher a company's net asset value, the higher the value of a company.
Net assets illustrate the assets owned by a company, as well as any debt that a company has. Companies with negative net assets are usually in financial trouble. One solution is to sell off assets to generate cash and pay off debts. Another is to renegotiate debt to lower payments or principals.
NEGATIVE OPERATING CASH FLOWS
Companies have to generate positive cash flow from operations, which will be used for investment and debt repayments. Negative cash flow is when a business spends more money than it makes during a specific period. When the company shows negative cash flows from operations and is using debt to bridge that gap, one sure deduction is that the company is in serious financial distress.