A firm’s financial flexibility is its ability to quickly raise new funds to meet a major fund need created by a crisis.
Flexibility aspects of the capital structure decision are very similar to risk problems and are analyzed in the same way. In contrast with a risk problem, a flexibility crisis is one of the large number of improbable but possible events that threaten the basic earning power of the business. These are events with which the firm and its management have little historic experience and therefore have no real knowledge of its ability to respond. It is a thing that goes bump in the night, in the words of the Scottish Book of Common Prayer.
How to solve flexibility problems?
Flexibility problems are not usually solved by converting assets into cash because the event will typically have damaged the value of the company’s assets and earning power. The resolution usually requires new external financing to purchase new assets, tangible or intangible. Occasionally, a firm faced with a flexibility crisis will have assets unrelated to its core business. These may be sold to generate funds to deal with the flexibility problem.
Risk vs Flexibility:
The differences between risk events and flexibility problems are of degree, however. One firm’s crisis may be a normal recurring risk problem for another. Risk and flexibility questions can be clearly distinguished at the extremes, but toward the middle of the spectrum they blend. A normal business cycle can usually be analyzed as a risk. A major depression is more likely to present a flexibility situation.
Example for flexibility problems:
Typical of memorable flexibility problems was the bankruptcy of Rolls Royce, which created a flexibility crisis for Lockheed because Lockheed had been counting on using new Rolls Royce engines in the 1011 jet airliner. Several unfortunate food companies have experienced flexibility crises when a product was found to be contaminated. Pharmaceutical companies have had flexibility crises created by sabotage. Weaker companies depending on the commercial paper markets experienced flexibility problems when Enron failed. Others have been severely threatened by governmental controls suddenly introduced or by sudden changes in foreign exchange rates. Scarcity of raw materials or other commodities can present unexpected and difficult problems. A rapid decline in prices also can cause problems, especially for those with unhedged inventory positions. These are all sudden unforeseen events striking at the core of the business.
Odds are that events of this type will occur from time to time for most companies. It is impossible economically and perhaps absolutely to get insurance or other forms of protection against all possible financial flexibility problems. Nevertheless, as with an individual’s financial program, some level of insurance is justified. The precise level depends on the size of the risks, the cost of the insurance, and the willingness of the entrepreneurs and the management to bear the risks. These considerations require careful analysis.
Analyzing the Flexibility Position
First, you must try to identify as specifically as possible the nature of potential financial flexibility events. Are they product-life problems, such as are found in high-technology business? Price-erosion threats? Receivables-collection or inventory problems? Loss of a major customer? Prolonged labor unrest’? Are there dangers in transfer of payments or international monetary disorders that might confront a company with significant international business’? Is the company possibly subject to pollution regulations for which compliance will require substantial funds?
Flexibility problems identified. What next?
Once the more likely financial flexibility problems have been identified (and you must be continually alert to changes in prospective flexibility problems), you must do your best to estimate the effect of these problems on the financial circumstances of the company. The more vulnerable the company is to one of these events and the more difficult it is for the company to rearrange its internal financial operations to generate funds to solve the problem, the more important it is for the firm to maintain easy access to outside funds. These can include debt capacity, new equity, or cash balances set aside for emergency, extraordinary purposes.
Flexibility Problem – Analytical approach & How to combat:
Although the case involved a sizable company, the analytical approach would be the same for the smaller business. The management of an automotive-parts producer identified events it thought constituted the major financial flexibility problems the company could face. These included the obsolescence of a major product line, substantial price cuts by competition attempting to buy market share, major additional requirements for research and development, major additional requirements for capital investment to attain the level of sales and profits expected, and failure of the company’s foreign affiliates to perform effectively.
Close examination showed that the most serious financial problems probably would be caused by product obsolescence, price problems, and cash drains of foreign operations. The other problems, in the judgment of management, would not cause a financial flexibility crisis. The serious problems were explored in detail. Using the best information available about what might happen (but never had), management tried to judge the company’s ability to marshal its internal resources to provide the funds necessary to survive these crises. Funds not available internally would have to be raised from the outside. Management found that $30 million in outside funds would likely be needed to combat either the obsolescence of a major product or a degenerating price situation. Foreign problems would require $20 million.
A sufficient reserve of debt to combat these problems plus a small reserve for odds and ends would absorb all the debt management believed the company could get from its financial sources. In fact, it might require that the small proportion of debt already on the books be refinanced with equity to create a full financial flexibility reserve. It certainly would force management to abandon plans to borrow additional debt to support prospective growth. But these actions were unattractive because issuing additional stock would dilute earnings and threaten the control enjoyed by the major shareholders group.
Management concluded the likelihood of one financial flexibility crises arising was strong enough to justify keeping some insurance in the form of debt capacity. The chance of two major simultaneous crises was so much less that full insurance was not required. The chance of more than two occurring simultaneously was so small that it did not justify, in management’s opinion, any further sacrifice of current benefits. Thus, in balancing the possible dangers of lack of resources against the immediate sacrifice of income, management decided the company should keep sufficient financial flexibility in the form of debt reserves to protect against one $30-million problem. Additional debt reserves should be kept to go toward another major problem or a combination of minor problems. Therefore, the debt reserve was set at $45 million.
Financial Flexibility problem: Reviewing the Minimax Situation
Although sufficient information has not been presented about The Minimax Company to allow a deep analysis of its financial flexibility situation, a brief comment on its general situation is a useful illustration. In the risk discussion above, it appeared that Minimax could barely service the proposed debt requirements in severe cyclical conditions. In addition, the basic nature of Minimax’s growth suggests the company should place a premium on maintaining an easy access to outside funds. Growth requirements will probably exceed internal-funds generation and require additional external financing. An issue of common stock in a time of poor earnings or in a poor stock market could result in a significant erosion of the owners’ control and perhaps require sale of the company to a larger firm.
It is thus unlikely that Minimax would have much room to maneuver if a flexibility crisis arose. The situation would be even more severe if the financial flexibility crisis coincided with a risk problem. Management must think carefully, therefore, whether the gain in ROE from using debt is sufficient to justify the commitment of most of the company’s flexibility reserves. The alternative is to raise equity in some manner or to trim the investment project, perhaps stretching it out for several years.
KEY POINT: Financial Flexibility aspects of a capital-structure decision are not easy ones to evaluate. The factors that must be considered vary substantially from case to case. The approach, in all cases, is the one outlined above, evaluating whether the trade-off in additional ROE is worth the loss of ability to raise funds in a flexibility crisis. The extra “eating” must be measured against the extra “sleeping.”