Warning signs of troubled companies: tightening liquidity. (Selected Topic).(lack of liquidity)

Tightening Liquidity

Liquidity is the lifeline of a company. Cash is king.. .as it deteriorates so does the company's ability to fund operations, reinvest and meet capital requirements including payments to the trade. With that said, a thorough understanding of an account's liquid health is essential when making credit decisions. At first glance, it is obviously ideal to see a company with a war chest of cash. However, cash as depicted on the balance sheet is merely a measurement at a specific point in time, which can be significantly lower the next day. Consequently, it is not unusual for a company to manage its balance sheet by short-term payment delays aimed solely at presenting the desired picture. Likewise, merely looking at a company's bottom line can be misleading, especially in light of the recent rash of accounting scandals. Now more than ever, close attention is being paid to Free Cash Flow (FCF), which cuts through the drawbacks of fancy accounting to establish how much cash a company has available for ongoing operatio ns, debt payments/reduction and activities such as expansion and acquisitions.

Free Cash Flow = Cash from operations

+ Interest Expense

- Capital Expenditures/Free Cash Flow

As you can see in the above formula, deteriorating FCF can easily be disguised by reducing capital expenditures. Accordingly, one must not only be wary of a decline in FCF but also a drastic drop in capital expenditures. Reducing expansion-related capital expenditures is typically the first line of action against deteriorating FCF and has little immediate effect on existing operations. Unfortunately, continued deterioration will compel the company to eliminate "necessary" capital expenditures, and will result in shoddy stores and outdated systems, thus accelerating the deterioration of operations. As FCF continues to deteriorate, the company will depend more and more on its credit facility. Therefore, a keen eye for events affecting a company's ability to borrow is a necessity.

In a perfect world, a retailer will only borrow against its credit facility when stock-piling inventory during the period prior to its peak selling season, since this is the time cash flows are the slowest. If the company is FCF positive, it should have the ability to repay some, if not all, the borrowings after the peak selling season. If not, year over year, borrowings will increase and the company's available credit will dwindle. Typically, a retailer's borrowings will be at their highest during the pre-holiday season, and at their lowest during the post-holiday season, as such, comparing credit availability at 9/4/02 to availability at 1/30/03 is almost meaningless. To effectively analyze a company's credit availability, it is important to compare availability at the same time each year vs. the prior year. If available credit declines, there should be a concern as to why. Other than an amendment to the size of the credit facility, there are three reasons why borrowing availability will deteriorate: (1) hi gher borrowings outstanding, (2) assets to support the borrowing base limit the amount the company can borrow, and (3) restrictive covenants. The latter two are often overlooked; however, play an important factor in liquidity. Typically, lending banks secure the loan with the assets of the borrower. Most often in the case of retailers, there is an advance rate applicable to eligible inventory and accounts receivable. In these cases, the banks will impose a borrowing base that will allow the company to borrow up to a percentage of eligible inventory plus a percentage of eligible accounts receivable. Accordingly, credit availability will decline as inventory and accounts receivable decline or the quality of the asset is questionable.