Is your balance sheet prepared for uncertain times?

More uncertainty lies ahead for the rest of 2020 and beyond. Sarah Boyce explores the capital structure implications and asks what treasurers can do

“There may be (more) trouble ahead…” – is your balance sheet prepared? 

Unsurprisingly, the initial response from many companies to the global pandemic was to ensure that they had continued access to liquidity to, in a very real sense, ‘keep the lights on’. Once again, cash was king. In practice, the unprecedented levels of uncertainty and the need to act very quickly meant that additional borrowing, in the form of bank loans or government-backed schemes, was the pragmatic solution for many.

Now that initial panic has subsided, companies need to focus on the longer term and start to explore how, having solved the immediate problem, they can assure the continued financial viability of their organisation. As the US Federal Reserve Chair Jerome Powell recently cautioned: “The recovery may take some time to gather momentum and the passage of time can turn liquidity problems into solvency problems.”

Treasurers should take the opportunity over the summer – while things appear relatively calm – to consider whether to address balance sheet structure to mitigate potential solvency problems.

More challenges

However, rebalancing the balance sheet will not be straightforward. A major challenge is the continuing high levels of uncertainty. 

Although uncertainty has receded from the extraordinary levels seen earlier in the year, by any measure (and the Bank of England has produced interesting research on this) the world is a more uncertain place – and looks to stay that way for the foreseeable future.

This uncertainty not only plays out in the volatility of the financial markets, but is also and more problematically for many corporates echoed in the wider economy. 

Nobody can be quite sure what shape any recovery curve might follow. Initially, there was optimism that this might be a ‘v’-shaped event. As time goes on, there is little clarity emerging on that. And looking at statistics doesn’t really help. 

For example, the stock market frequently rebounds within a year or so of a major event, but many governments were only recently easing out of spending controls some 10 years after the global financial crisis. 

When forecasting recovery for their organisation, the treasurer will need to rely on knowledge of the business – and the business strategy that has no doubt been revised since January.

Back to basics

If one considers capital structure from first principles, the balance between debt and equity would be optimised and there would potentially be a range of debt and equity solutions accessed in order to diversify risk while minimising cost.

With interest rates at historic lows, the ability to cover interest costs (and the related covenant compliance) is possibly the limiting factor when looking at total debt levels – particularly given that the process of raising debt is generally cheaper and quicker than any equity-related solution. Nevertheless, the treasurer should consider whether rebalancing the balance sheet through issuing equity (or some sort of hybrid – as they are once again back in fashion) provides greater long-term security for the organisation. After all, equity, generally, is permanent capital.

There are a couple of other considerations that may also influence the decision to issue equity: 

• Rating agencies. For those organisations with a credit rating, it’s very important to make sure that the agencies are kept up to date with developments and thinking. The last thing any corporate needs right now is a ratings downgrade or negative outlook flag. Keeping the agencies informed, even if the news is not particularly positive, enables more constructive dialogue. Rating agencies have had their fingers burnt too many times in recent years, so if they feel ‘out of the loop’ for any reason, there is a real risk that they will jump first and ask questions later.

• Investors. Both debt and equity investors will be reviewing their portfolios and identifying those they’d prefer to retain. At this point, ESG considerations will almost certainly play a role. Again, communication is key to making sure that investors are there when you need them. This will be particularly relevant if the organisation decides to raise additional capital as, for example, shareholder rights (such as pre-emption rights in the UK) will complicate any capital-raising process.

The treasury mantra of ‘be prepared’ has, by necessity, been overtaken in recent months, but there is now an opportunity for organisations to actively review their balance sheet and determine what an optimum structure may look like. 

Current conditions, and in particular the high levels of uncertainty across the markets, may make an optimum capital structure unachievable, but it’s important to know where to aim for… not least because by increasing the equity proportion of the balance sheet the treasurer will be positioning the organisation for the next pandemic. 

The ‘new normal’ is almost certainly greater global economic uncertainty. 

About the author

Sarah Boyce is associate director of policy and technical at The Association of Corporate Treasurers