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How to stress-test a business’s finances

You can build up a good picture of a business’s chances of surviving turbulent markets from its balance sheet – but referring back to previous cycles will bolster your understanding of what might happen next

13/05/2020

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Having previously covered Why balance sheet strength matters, let’s now consider how we might best work out a business’s chances of surviving future periods of market turbulence. What we first try to understand, here on The Value Perspective, is the potential variability of cashflows and profits but, rather than think only about the coming months and years, we also refer back to prior cycles to understand what happened then.

To assess the potential impact on profits, we can then roll our model forward based on the gross margin the company discloses. As this is often more of an accounting concept than a true reflection of the economics of the business, however, we have models that go back for at least an entire cycle. That way, we can see what actually happens as opposed to relying on an accountant’s interpretation of the definition of ‘gross margin’.

Next we need to work out the operating leverage the company has traditionally exhibited as this allows us to model what will happen should the business become insolvent in the near term. That said, issues with a company’s balance sheet rarely stem from its solvency but from its liquidity – how easily it can turn its assets into cash – which brings us to the next stage of our balance sheet stress-test.

Short-term liquidity

What we are looking to understand here is what money is coming into and heading out of the business, what cash buffers and undrawn facilities exist and whether it has unencumbered assets – that is, assets that could be either used as security for a loan or sold quickly to raise liquidity. That would not have to be a permanent disposal – it might be a ‘sale and leaseback’ transaction – but the principal aim is the generation of cashflows in the short term that could potentially buy time.

We also want to understand what covenants the business has because, if the balance sheet is weak and the company breaches any of its obligations, that puts the lender in the driving seat – not the shareholders. And we want to understand when any debt matures because, if that happens when the company is going through a tough time, again, that gives the lender the whip hand.

Next, we want to understand what commitments the business has already made – to capital expenditure, for example, or to dividends – that will be a drain on cash. We will also need to carry out an analysis on the sensitivity of those potential consumptions – particularly with regard to the impact of a downturn on a business’s working capital.

Cycle’s worth of data

Once again, investors can choose solely to be guided by the company’s numbers and accounting definitions but the benefit of our modelling process – of having at least a cycle’s worth of data – is that we can see what happened last time and so understand the real implications of a downturn. We can then check if, say, the working capital to sales ratio is reflective of how the business will operate through a cycle.

Finally, we ask a number of questions experience has taught us are useful in understanding what can happen to a company during tough times – for example, does its financing come via the bond market or banks? It tends to be far easier to renegotiate debt with banks than the bond market – but, then, does the loan come from one bank or a panel? If it is the latter, any renegotiation process will be longer and more complex.

Then again, ‘having all your eggs in one basket’ might turn out to be a weakness – if the single lender is itself going through a tough patch at the same time as the borrower, that potentially brings risk. So understanding all the different ways this may play out – the various stresses on the financing; whether there are any ‘levers’ that can be pulled to shore up liquidity in the short term – is important.

Loan-to-value

The key here is to understand whether the real issue is too much debt or not enough profits. To return to our mortgage analogy of the previous piece, if you were to lose your job, it does not mean your mortgage is unsustainable but, rather, your income is too low – hopefully only temporarily so. In due course, the loan-to-value ratio of the mortgage may still turn out to be appropriate – and the same holds true in the context of a company’s balance sheet.

Loan-to-value is potentially a key metric here because the EBITDA (earnings before interest, taxes, depreciation and amortisation) for a cyclical business can go to zero. That means its net debt to EBITDA ratio could look very elevated – even if it only had £1 of debt. Gauging whether it is the quantum of debt that is the issue can therefore be key to understanding a company’s real chances of survival.

As soon as it became apparent how significant an impact the present environment would have on company profits, then, this is the process we undertook with every single business we own – re-reviewing each one to ensure our defences were solid, just as we explained a year or so back in Why you should, frankly, give a dam about company balance sheets.

As we wrote more recently in History is telling investors now is a time to be brave, current valuations suggest this is a genuinely attractive entry point to equities. Nevertheless, before we ventured out to try and take advantage of the potential opportunities that exist in the marketplace, it was first vital to make sure the foundations of our portfolio remained strong and secure.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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