Can the company repay its debts?

The best way to answer this simple, fundamental question is to take the company’s business plan and project future cash flow statements. These statements will show you whether the company generates enough cash flow from operating activities such that, after financing its capital expenditure, it has enough left over to meet its debt repayment obligations without asking shareholders to reach into their pockets. If the company must indeed solicit additional equity capital, you must evaluate the market’s appetite for such a capital increase. This will depend on who the current shareholders are. A company with a core shareholder will have an easier time than one whose shares are widely held. It will also depend on the value of equity capital (if it is near zero, maybe only a vulture fund1 will be interested). Naturally, this assumes that you have access to the company’s business plan, or that you can construct your own from scenarios of business growth, margins, changes in working capital and likely levels of capital expenditure.

Analysts have in the meantime adopted a ‘‘quick-and-dirty’’ way to appreciate the company’s ability to repay its debt: the ratio of net debt to EBITDA.2 This highly empirical measure is nonetheless considered useful, because EBITDA is very close to cash flow from operating activities, give or take changes in working capital corporate and income tax. A value of 4 is considered a critical level, below which the company should generally be able to meet its repayment obligations.

If we were to oversimplify, we would say that a value of 3 signifies that the debt could be repaid in 3 years provided the company halted all capital expenditure and didn’t pay corporate income tax during that period. Of course, no one would ask the company to pay off all its debt in the span of 3 years, but the idea is that if it had to, it could. Conversely, bank and other financial borrowings equal to more than 4 times EBITDA is considered a heavy debt load, and gives rise to serious doubts about the company’s ability to meet its repayment commitments as scheduled. When the value of the ratio exceeds 5 or 6, the debt becomes ‘‘high-yield’’, the politically correct euphemism for ‘‘junk bonds’’.

Bankers are more willing to lend money to sectors with stable and highly predictable cash flows (food retail, utilities, reference books, etc.), even on the basis of high net debt to EBITDA ratio, than to others where cash flows are more volatile (media, capital goods, etc.).

The functions of a financial system

The job of a financial system is to efficiently create financial liquidity for those investment projects that promise the highest profitability and that maximise collective utility.

However, unlike other types of markets, a financial system does more than just achieve equilibrium between supply and demand. A financial system allows investors to convert current revenues into future consumption. It also provides current resources for borrowers, at the cost of reduced future spending. More specifically, we have three definitions of efficiency:

• informational efficiency refers to the ability of a market to fully and rapidly reflect new relevant information;
• allocative efficiency implies that markets channel resources to their most productive uses;
• operational efficiency concerns the property of markets to function with minimal operating costs.

Robert Merton and Zvi Bodie (2000) have isolated the six essential functions of a financial system:

1. A financial system provides means of payment to facilitate transactions. Cheques, debit and credit cards, electronic transfers, etc. are all means of payment that individuals can use to facilitate the acquisition of goods and services. Imagine if everything could only be paid for with bills and coins!

2. A financial system provides a means of pooling funds for financing large, indivisible projects. A financial system is also a mechanism for subdividing the capital of a company so that investors can diversify their investments. If factory owners had to rely on just their own savings, they would very soon run out of investible funds. Indeed, without a financial system’s support, Nestle´ and British Telecom would not exist. The system enables the entrepreneur to gain access to the savings of millions of individuals, thereby diversifying and expanding his sources of financing. In return, the entrepreneur is expected to achieve a certain level of performance. Returning to our example of a factory: if you were to invest in your neighbour’s steel plant, you might have trouble getting your money back if you should suddenly need it. A financial system enables investors to hold their assets in a much more liquid form: shares, bank accounts, etc.

3. A financial system distributes financial resources across time and space, as well as between different sectors of the economy. The financial system allows capital to be allocated in a myriad of ways. For example, young married couples can borrow to buy a house or people approaching retirement can save to offset future decreases in income. Even a developing nation can obtain resources to finance further development. And when an industrialised country generates more savings than it can absorb, it invests those surpluses through financial systems. In this way, ‘‘old economies’’ use their excess resources to finance ‘‘new economies’’.

4. A financial system provides tools for managing risk. It is particularly risky for an individual to invest all of his funds in a single company, because if the company goes bankrupt, he loses everything. By creating collective savings vehicles, such as mutual funds, brokers and other intermediaries enable individuals to reduce their risk by diversifying their exposure. Similarly, an insurance company pools the risk of millions of people and insures them against risks they would otherwise be unable to assume individually.

5. A financial system provides information at very low cost. This facilitates decision-making. Securities prices and interest rates constitute information used by individuals in their decisions about how to consume, save or divide their funds among different assets. But research and analysis of the available information on the financial condition of the borrower is time-consuming, costly and typically beyond the scope of the layman. Yet when a financial institution does this work on behalf of thousands of investors, the cost is greatly reduced. Unfortunately, this does not mean that financial systems always handle information perfectly. For example, herd behaviour occurs when investors move in pack-like formations and make decisions by following what everyone else is doing in the market. Such phenomenon can make the price of an asset diverge from its fundamental value. This is precisely what happened with Internet stocks in late 1999 and early 2000.

6. A financial system provides the means for reducing conflict between the parties to a contract. Contracting parties often have difficulty monitoring each other’s behaviour. Sometimes conflicts arise because each party has different amounts of information and divergent contractual ties. For example, an investor gives money to a fund manager in the hope that he will manage the funds in the investor’s best interests (and not the manager’s!) If the fund manager does not uphold his end of the bargain, the market will lose confidence in him. Typically, the consequence of such behaviour is that he will be replaced by a more conscientious manager.

The relationship between banks and companies

Bank intermediation is carried out first and foremost by commercial banks. Commercial banks serve as intermediaries between those who have surplus funds, and those who require financing. The banks collect resources from the former and lend capital to the latter. Based on the strength of their balance sheet, commercial banks lend to a wide variety of borrowers and, in particular, to companies. Banks assume the risks related to these loans; therefore, their financial condition must be sufficiently strong to withstand potential losses. However, the larger the bank’s portfolio, the lower the risk – thanks once again to the law of large numbers. After all, not every company is likely to go bankrupt at the same time!

Commercial banking is an extremely competitive activity. After taking into account the cost of risk, profit margins are very thin. Bank loans are somewhat standard products; therefore, it is relatively easy for customers to play one bank off against another to obtain more favourable terms.

Commercial banks have developed ancillary services to add value to the products that they offer to their corporate customers. Accordingly, they offer a variety of means of payment to help companies move funds efficiently from one place to another. They also help clients to manage their cash flows. As a result, the growing importance of financial markets has changed the role of bankers. They have developed services to help their corporate clients gain direct access to capital markets, leading to the rise of investment banking. Investment banks offer primarily the following services:

Access to equity markets: investment banks help companies prepare and carry out initial public offerings on the stock market. Later on, investment banks can continue to help these companies by raising additional funds through capital increases. They also advise companies on the issuance of instruments that may one day become shares of stock, such as warrants and convertible bonds.

Access to bond markets: similarly, investment banks help large- and mediumsized companies raise funds directly from investors through the issuance of bonds. The investment bank’s trading room is where its role as ‘‘matchmaker’’ between the investor and the issuer takes on its full meaning.

Merger and acquisition advisory services: these investment banking services are not directly linked to corporate financing or the capital markets, although a public issue of bonds or shares often accompanies an acquisition.

Asset management: certain banks use their knowledge of the financial markets to offer their clientele – individuals, companies and institutions – investment products comprised of portfolios of listed or unlisted securities. These products are called mutual funds and the activity is known as asset management.

For a long time, these various lines of business were separated for regulatory reasons. Today, they coexist in all major American, European and Asian financial institutions, although not without potential conflicts of interest. A creditor is not always a disinterested party when it comes to advising a corporate client.