Focus on Optimal Capital Structure or Face the Moment of Truth
By Dennis DiPietre and Lance Mulberry
If you have found yourself wondering when we will finally return to normal, I have some bad news. Normal moved away and did not leave a forwarding address. Instead of pining away for a return to normal, focus your attention on optimal capital structure (the amount and terms of your outstanding debt and the availability of cash). If this seems out of your wheelhouse, make an appointment with your lender to discuss it.
Like most well-worn rules of finance and business, the rules about optimal capital structure, memorized by freshman college students in nearly every finance or economics class, have an assumption underlying them that the professor probably didn’t mention. That’s because they were in normal times. Now that normal is only a memory, all those rules should be tossed out the window.
Optimal capital structure refers to the organization of debt into time frames which roughly match the useful life of the assets for which the debt had been taken. Due to risk, the time frames for debt are usually shortened compared to the useful life of the assets so that no debt outlives its asset.
The term for debt outliving an asset is to be “upside down.” In simple terms, as cash inflow occurs, it is allocated first to expense payments, which also includes current interest on any debt and as well as the current portion of principal debt, then to other things. If there is excess, it can be used for new capital acquisition, further debt reduction or simply retained to meet future obligations.
The critical centerpiece of optimal capital structure is liquidity. Liquidity refers to a business’s ability to pay upcoming short-term debt with incoming and available cash. Keep in mind that available, unused credit and the proceeds from assets which can be liquidated quickly without loss of value are “cash” for these purposes.
A liquidity ratio of at least one-to-one has been considered safe during non-turbulent times. The meaning of this general rule of thumb is if each period (month) you have cash in an amount necessary to cover all the expenses currently due, you are safe. If you are taking comfort from this rule, let me be the first to inform you that you are no longer safe, not even close.
What the professor failed to mention was that if future income or expenses are subject to increasing amounts of risk, more cash reserves are required, and “safe” liquidity ratios increase as do their corresponding coverage ratios for longer term debt. As we look out into the future, safe liquidity ratios seem most likely to be in the range of 1.5 to 2.0 and could grow higher.
For most producers, this means stopping all unnecessary spending to strive to build a liquidity ratio where the available cash is more than the current debt due. This construct assumes operating expenses are paid from current cash or a line of credit which is then already included in short-term or current debt. If you are too late to begin that process, reduce expenses as dramatically as possible, begin the process of selling all unnecessary assets and try to wait out the current situation.
Most producers in the U.S. are currently losing an estimated $40/head (although the variance around this is large). Since debt of all kinds (short-term and long-term) cannot be retired when the basic expenses of production are unpaid, debt rises dramatically during these times of loss. As this happens, the moment of truth moves closer each week. If you make it through this, bump up that liquidity ratio because, like it or not, the next random shock is already on the horizon.
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