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Safeguarding Your Liquidity

Capital needs are covered and maturities are pushed out. What could possibly go wrong?
Vincent Ryan, CFO Magazine
September 1, 2011

While the corporate debt set to mature between now and 2015 totals a whopping $8 trillion, in the short term it helps guarantee that most companies will have their liquidity needs covered for three years. The 2010–2011 bond-market resurgence and cheap bank loans stemming from competition for borrowers made for an ideal time to roll over or refinance debt.

But there's more than liquidity at issue when it comes to managing debt on the balance sheet. Once a loan agreement is negotiated and signed and money changes hands, CFOs face a new set of tasks. And as much inexperience as some CFOs have with negotiating a loan or issuing a bond, many more lack experience at maintaining a dialogue with lenders and tip-toeing around the technical land mines in loan documents.

Ignoring the details of outstanding debt, however, can come back to bite a company. Many CFOs, for example, may not realize how easily a loan covenant can be tripped and a company put into default. "The consequences of default are incredibly ugly," says Jeff Wallace, co-founder of Debt Compliance Services, provider of a Web-based covenant-management system. At a minimum, "with public disclosure, customers may start thinking about having second suppliers, and vendors might want cash on delivery. You'll have to live on cash, because cross-defaults mean you can't borrow. And you'll pay penalty interest [an additional 200 basis points] on the debt."

Short of actual default, poor communication with lenders and bondholders also has consequences. Banks abhor surprises, and an executive management team that neglects to inform its lender of material changes in the business model or forecasts risks being labeled uncreditworthy. A lender kept in the dark is also much less likely to get on board when new capital needs arise.

Below are five different ways CFOs can maintain good lender relations and access to capital:

Loan requirements that could cause default

1) Watch thy covenants. At their peril, many CFOs simply stuff loan documents into a filing cabinet and forget about them. They may monitor debt-service coverage ratios, but miss nonfinancial requirements. Jim Simpson, co-founder of Debt Compliance Services, says one of his clients neglected to register a 144A bond issue with the Securities and Exchange Commission and violated its credit agreement by not paying the penalty interest on time. "The company wound up in default, the auditors issued a material weakness, and the company was unable to access any credit until it got the problem fixed with the bondholders," he says.

A borrower can get into a different kind of pickle with secured debt. A company may have an obligation to the lien holder to inform it when it disposes of an asset. Furthermore, secured loans sometimes require mandatory prepayment with the proceeds from the asset sale. "We're often not talking about a huge asset — maybe some obsolete equipment sitting on a plant floor that a plant manager sells to a junk dealer for $10,000," says Wallace. "Does the treasurer know where the $10,000 in the account came from? No." Companies often fail to train people on what they can and cannot do per the debt agreement, Wallace says.

What complicates any kind of covenant break are the counterparties on the other side of many business loans: institutional money or even hedge funds. "In the good old days, you'd take your banker out to lunch, confess your sins, and the banker would give you a small penance over the table and absolve you," says Wallace. "Now you break a covenant and the agent has to talk to the other syndicated lenders."

2) Maintain interest (rates). If a company has variable-rate debt, it should protect its cash flows against any unexpected volatility, says Bill Fink, executive vice president of commercial banking at TD Bank. "Laddering" maturities through interest-rate swaps is one way. A company can break the debt into chunks and get a fixed rate of interest on segments of the debt for different periods. "When the swap matures at, for example, 18 months and the rate goes back to floating, you can renew the swap for a short time or apply excess cash flow to retire the debt early," says Fink.

Interest-rate risk — in particular the mix of fixed-rate and floating-rate debt — is something that CFO Steve Fisher and his finance team at Novelis, an $11 billion producer of aluminum rolled products, continually examine. When the company revised its capital structure in 2010, it took on 65% of fixed-rate debt and 35% of floating. "We think that's a nice, natural hedge of the economy, having that amount of floating-rate debt," says Fisher. Novelis does business in 11 countries, but the debt is tied to U.S. rates and the U.S. economy.

One determinant of the level of fixed versus floating is the robustness of economic recovery in places outside the United States, like Europe or South America. "If those regions' recoveries get ahead of the U.S., we might rebalance and take on a little bit more fixed," Fisher says. That would enable the company to hold rates low while investing in new growth overseas.


The other aspect of interest rates that Novelis proactively manages is market opportunity. Three months after arranging a variable-rate, $1.5 billion term loan last December, Novelis refinanced the loan, dropping the spread by 75 basis points and reducing its LIBOR floor by 25 basis points. "We saw no more than a two-year payback on the upfront costs, and we didn't see taking out this debt for a minimum of three to four years," says Fisher.

3) Stay secure. Asset-based loans come with their own challenges. Foremost is the care taken with the loan's collateral — receivables or inventory. Receivables have to be collected on a timely basis, and inventory has to move quickly. For inventory, CFOs must work with sales and marketing to make certain the company is investing in products "that will sell and maintain their value, and move through so they can generate cash flow," says Kevin McGarry, an executive vice president at asset-based lender First Capital. If a product ages past 90 days, for example, it typically goes off the borrowing base.

Developing and staying on top of a rigorous collection process, on the other hand, helps in two ways: it maintains a higher level of borrowing, and faster collections lower interest-rate costs. "If days sales outstanding decreases by three days, the company is paying three days' less interest," McGarry says.

Communicating with the secured lender is also critical. If a company plans to accelerate capital spending, for example, or utilize more working capital to support equipment purchases, or build up inventories sooner in the cycle to support larger customers, the lender needs to know, says McGarry. "We have to have time to understand and underwrite that strategy and get it in front of the appropriate credit committees," he explains.

4) Forge bonds. Debt issuers should also recognize the premium placed on communicating the business strategy. "I think a lot of times high-yield bondholders get lost in the capital structure," Novelis's Fisher says. The issuer also needs to recognize that fixed-income investors want to hear about cash, not earnings per share.

Novelis takes bondholder dialogue seriously. It holds quarterly conference calls, visits bondholders on road shows, and attends a number of high-yield conferences. "I can't tell you how much that has paid off in bond-buying interest," says Fisher.

One of the key expectations Fisher sets with Novelis bondholders is the firm's target leverage ratio. "We don't want to have a lazy balance sheet," he says. Novelis sets a target debt-to-equity ratio of between 3.5 and 4 to 1. "If we drop below that, bondholders understand that we're probably going to do something with that excess capacity, like return it to equity holders," Fisher says. Another option Fisher would consider is to pursue merger-and-acquisition opportunities.

5) Assessing need. Does a company with a giant cash cushion need debt at all? The deleveraging question entails a host of considerations that are company-specific, of course. Debt still has tax advantages, for example. But carrying debt that has no productive purpose makes no sense.

The decision to deleverage should be determined by a company's strategic plan, says TD Bank's Fink. "What does the plan allow for in a reasonable time horizon? If the company is not going to make an acquisition, has an adequate working-capital cushion, and has a very low return on the cash, it probably makes sense to reduce the level of debt," Fink says.

Data from corporate balance sheets indicates that some companies have deleveraged, but debt-to-income levels remain high. And many companies may go back to their lenders and bondholders before their debt matures for more credit to fuel investments that will increase sustainable growth.

It behooves CFOs, therefore, to stay close to creditors. Otherwise, they risk another liquidity shortage — a situation that few CFOs would find easier to manage than the current one.

Vincent Ryan is senior editor for capital markets at CFO.




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