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A company going broke or into business rescue is something we’re seeing more with listed shares. As investors we naturally want to avoid holding shares of companies that hit business rescue because shareholders can expect very little from it, if anything.
The cause of bankruptcy is not just debt, but extends to the liquidity and solvency of a business. A company like Tongaat Hulett is technically bankrupt with its negative net asset value of around R4bn.
Simply put: Tongaat’s liabilities exceed its assets by R4bn. But the business rescue practitioners are unlikely to be summoned, whereas other companies in a similar position could find themselves faced with a business rescue process.
What sets Tongaat Hulett apart is its ability to trade itself out of trouble. There are a few simple options companies in this position can consider.Firstly, they could sell some of their assets.
In mid-February Tongaat issued a cautionary announcement stating that it’s looking to sell its starch business. With a R300m profit for this unit for the six months through the end of September 2019, the sale would go a long way to plugging that R4bn hole.
Ascendis Health is another example; it’s looking to sell its Remedica business unit in Cyprus to shore up its balance sheet. The difference being that starch is not really a core business to Tongaat, while Remedica is a gem that Ascendis plans (and needs) to sell.
A second option for companies teetering on bankruptcy is talking to lenders and bankers to revise the terms of their loans, particularly extending the duration and/or temporarily halting repayments. This works, but boils down to just kicking the can down the road.
Lenders don’t consider this a long-term solution, so it’s just a temporary fix while management tries to sell assets – as is the case with Ascendis.
The big issue at play is this: Can the company carry on trading and paying its staff and suppliers while it remains under this pressure?
If they can, then they stand a good chance of surviving. But if they can’t, then it’s the business rescue practitioner for them.
Investors can keep an eye on all the details explored above, but you can also consult some key liquidity ratios that can help you get ahead of the crisis or understand just how bad it is.
Some of the ratios I like are the solvency ratio – which includes short- and long-term financial obligations – and the current and quick ratios, which focus on a company’s short-term debt obligations and current assets.
(Remember that “current” means assets or liabilities that are convertible into cash within 12 months).
The solvency ratio takes the company’s after-tax operating income and divides it into its total debt obligations to determine the company’s ability to meet its debt obligations.
A result of more than 20% is good, but total debt obligations are not always a fair reflection, as some of that debt may be a way off from being called or paid.
The current ratio divides current assets by current liabilities to determine the company’s ability to meet its short-term obligations.
The concern here is how liquid these current assets are. Sure, they’re easy to convert into cash, but at what price? So, when considering a company’s current assets, I like to use its cash on hand.
We can also look at the quick ratio (also known as the acid test) – a company’s quick assets divided by its current liabilities.
Quick assets are current assets less inventories. Inventories are current, but they’re needed to operate the business, so they’re not able to be sold down aggressively.
Because we’re using current liabilities due within a year, we want the ratio to be higher than 100%. Anything below that level means the company could be caught short paying this year’s debt obligations.
Used collectively, these ratios will all help you gauge if a company is about to call business rescue experts or not.
This article originally appeared in the 5 March edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
