Game theory


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

When considering whether a company is in danger of going bust, most investors will tend to focus on its levels of debt. However, the relationships a business has with its suppliers, customers and trading partners, the so called “terms of trade”, are also worthy of attention in this regard – to a much greater extent than is often realised -  because they can play a big part in shaping where a company’s debt position ends up.

Take the example of video game retailer game group, with whom a number of key suppliers are now reluctant to do business – the natural inference being such companies are less than convinced they will receive payment for the games or whatever else they send game’s way. Under more normal circumstances, game might expect, say, a 60-day grace period from its suppliers between receiving, say, a batch of a popular game from them and actually paying them for it, which works well for a retailer like game because they will themselves tend to receive immediate payment from their own customers.

However should a company lose the confidence of its suppliers this grace period may be shortened or even withdrawn completely, meaning it has to start paying for merchandise upfront. The result is that the company has to start tying up more cash in its business to continue operating as normal, which is likely to involve drawing more on its bank facilities thereby pushing up its debt levels. In a sense the ‘credit’ that was being provided to the company by its suppliers is lost has to be replaced with ‘credit’ in the form of bank debt. Eventually a company might exhaust the headroom on its bank facilities and its banks will then have to take a view on whether or not to extend them.

Using game as an example again – although there are a number of other companies, particularly in the retail sector, that are or have been in this position – as of January 2011, the company had some £120m net cash on its balance sheet, which obviously seems a very strong position. However, over the six months to the end of July 2011, the company saw an outflow in cash generated from operations of £186m, a much bigger outflow than the £74m for the corresponding six months the previous year.

Negative cash flow over part of a year isn’t unusual for a retailer - it’s the difference in the size of the cash outflows that’s significant.  Compared to the year before game had to find an additional £112m of cash to fund the running of its business and £59m of this change was due to changes in the amount of cash game had paid out to suppliers in the period.

Ultimately if a retailer can’t access cash to pay its suppliers then this puts it in a very difficult position, after all if a retailer has nothing to sell, it becomes very hard for it to make profits and generate cash to improve its financial position. All of which goes to underline the importance of investors paying attention to all lines of a company’s balance sheet and understanding how changes in a business’ terms of trade might impact its financial position rather than simply focusing on the absolute debt reported in a business’s year-end accounts.



Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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