The credit crisis of late 2008 has spilled into 2009, and the lack of funding has hampered the ability of many corporations to make the ideal operating and investment choices. We recently completed an in-depth study of how tight credit is affecting corporate activity.
When a company is able to invest in positive net present value (NPV) projects, this means that the project returns more than the company’s cost of capital, thereby increasing firm value in the long run. When credit is tight, as it is now, companies are not always able to obtain the necessary financing to pursue positive NPV projects. Due to the current credit crunch, more than half (55 percent) of U.S. companies tell us that they have recently had to cancel or postpone positive NPV projects. European and Asian companies are in a similar situation. This is bad for the economy in the long run because it spreads the effects of the current credit crisis into the future – less cash flow will be produced one or two years from now due to the cancellation of good projects today.
Limited liquidity can hurt any company, but the problems are most acute among firms with poor credit ratings. For these firms, credit markets have nearly shut down. When external borrowing is limited, a company must rely more on internal funds, such as profits, asset sales, or cash on the balance sheet. For low-rated firms, profits are often poor, further limiting options.
In our analysis, we found that struggling U.S. firms started 2008 with cash and marketable securities on the balance sheet equal to about 15 percent of total assets but ended the year with cash and marketable securities amounting to only 12 percent of assets. These financially constrained firms burned through a startling one-fifth of their cash holdings in just one year’s time. Again, similar patterns are observed in Europe and in Asia. On the bright side, companies that are stronger financially were able to maintain cash of about 15 percent of asset value. Ironically, this indicates that most financially strong firms should not need to borrow extensively from credit markets, even though these are the only firms for which credit markets remain fairly open. In contrast, low-rated firms are burning through their internal reserves, while at the same time finding limited access to external sources of funding.
What can a poorly performing firm do if it has limited profits, shrinking cash reserves, and little access to external capital? One option is to sell assets in order to obtain funds. Among firms that tell us they have experienced problems accessing credit markets, an astounding 56 percent indicate that they have sold assets in order to free up funds for other uses. While it is possible that some companies are finally shedding underperforming divisions (which would be a good thing), when you consider the depressed state of asset markets, it is likely that many of these recent asset sales have occurred at fire sale prices. Thus, asset sales have provided little relief.
Firms that are struggling to access new capital can also rely on previously established lines of credit. Normally, credit lines are used for temporary “bridge” loans or as a short term substitute for cash. Today, we find evidence that lines of credit are instead serving as a “last resort” source of funds. U.S. firms have lines of credit with maximum borrowing capacity equal to about 23 percent of total asset value on average. We also find evidence that credit lines do in fact substitute for cash in that firms that have less cash on the books have a tendency to maintain larger credit line capacity.
What is most astonishing about our credit line analysis is the degree to which they are currently drawn down. The typical U.S. company has drawn about 38 percent of the maximum allowable borrowing on its credit line. Companies with credit ratings of A or higher have drawn down less than 30 percent of maximum on average, while companies rated BBB or BB have drawn nearly 40 percent of the maximum allowed by their credit lines. Notably, companies rated B or lower have drawn nearly 70 percent of their line of credit capacity. This is alarming because it indicates that poorly rated firms have nearly used all available debt capacity.
This draw down on credit lines among poorly rated firms has been exacerbated by a “just in case” phenomenon at some companies. That is, many poorly rated companies are drawing on their credit lines now as a precaution, fearing that their banks will eliminate their credit lines in the future (if, for example, the firm were to violate a covenant, which would restrict future credit line access). While this “bank run on the credit line” strategy has some logic to it, the previously mentioned evidence on shrinking cash reserves at poorly rated firms suggests that this strategy has at best slowed the bleeding of cash among these companies.
Moreover, this extensive credit line borrowing by distressed or near-distressed firms must to some extent deplete the funds that banks would otherwise have available to lend to healthier firms, thereby hurting the economy indirectly.
Overall, our study suggests that poorly rated firms have few options left available to them. Unless the overall economic tide soon rises, the long-term outlook for struggling companies looks bleak.
John Graham is the D. Richard Mead Jr. Family Professor of Finance at Duke University’s Fuqua School of Business
Kate O’Sullivan is a Senior Writer at CFO Magazine
Each quarter the Duke University / CFO Magazine Global Business Outlook Survey polls thousands of chief financial officers around the world. The most recent survey concluded February 27 and reflects the views of 1,268 CFOs in the U.S., Europe, and Asia. This blog draws on the February 2009 and November 2008 surveys. The survey has been conducted 52 consecutive quarters. See http://www.cfosurvey.org for more details.