Financial resilience has become something of a buzzphrase during the economic fallout from the coronavirus crisis. Those businesses levered to the hilt, or with a long-history of negative cash flow, or both, have struggled to access the financial markets except on usurious terms. Conversely, seemingly less aggressive businesses with cash buffers and functional business models have accessed financing with relative ease.
A new working paper has quantified this divide between the haves and have-nots when it comes the riskiest of all corporate asset classes -- equity -- and has found that when the going gets tough, the financially flexible get going.
The paper, by three academics from Europe and the US looks at the performance of a sample of non-financial firms from the onset of the crisis, which they set as February 3, through to the Federal Reserve’s monetary kitchen-sinking on March 22, and then beyond.
The results will be of little surprise to market-watchers. Companies deemed “financially flexible”, which the academics define as those that can survive a cash-flow shortfall with ease, performed better in the market collapse than those with less financial wiggle room.
When we consider stock returns, we find strong evidence that firms with more financial flexibility are less affected by the COVID-19 shock during the collapse period. These firms also benefit less on stimulus day [March 22]. Specifically, controlling for known determinants of stock returns, we find that firms with less short-term debt, more cash, and less long-term debt experience a lower stock price drop in response to the shock.
However, what we thought was worth drawing your attention to was which determinants of financial soundness mattered, and which didn’t.
For instance:
However, among these variables, the ratio of long-term debt to assets is most consistently significant. We expect that firms with relatively more short-term debt to be more affected by the shock as they have to refinance more debt in the short-run when the financial system may be stressed. Yet, we find typically no difference between the coefficient on short-term debt and the coefficient on long-term debt.
Now that is curious. You’d expect companies who need to refinance larger chunks of debt in the short term to have larger share price dislocations, given it looked like capital markets might shut completely before the Fed’s nuclear assault.
There is one explanation Alphaville can think of for this. Your average equity investor, perhaps concerned with her cash flow forecast or even more traditional measures of debt such as net debt, arguably pays less attention to the maturity profile of a company’s liabilities than you’d perhaps expect.
This is understandable when times are good, as a company’s cash flow profile shouldn’t waiver considerably year-to-year. When revenues go to zero however, and you suddenly have a convertible bond maturing that needs to be paid in cash (which is more likely in a market dislocation, given share prices tend to fall), it becomes a tad more problematic.
So perhaps if there’s something to be taken from this paper, it’s that during market dislocations investors get scared easily by a high debt figure, but not the maturity profile of that debt.
Yet, in reality, this is perhaps what matters most. Companies with lots of leverage, but no need to refinance soon, have a much longer runway than those with a bevy of bonds maturing sharpish.
It sounds obvious, but it seems not everyone is paying attention.
Related Links:
Pandemics and the question of resilience -- FT Alphaville
"Market" - Google News
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Financial flexibility and market dislocations - Financial Times
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