In reviewing your company’s strategic and financial situation, it is useful to identify the “Capital position” in which the company is operating. This is particularly useful when preparing sensitivity analyses that will identify the conditions that might move the company from one position to the next. The four positions of states are:
- Paying net debt
- Maintaining the existing dollar amount of debt
- Increasing the dollar amount of debt, but not the leverage ratio
- Increasing the leverage ratio
Capital position 1
Net repayment of debt, as already noted, is characteristic of a mature or declining company. Such a company no longer needs resources to support growth and does not yet need them to stave off decline. This company is not a very good customer for loans from a financial institution. It may be a customer of the bank’s money-market desk or syndication department as management looks for assets in which to invest the company’s liquidity. This is often a safe company for a financial institution to have as a customer as long as it is careful to avoid being drawn into financing a company in an irreversible downward spiral to costly liquidation.
Capital position 2
It is rare for a company to maintain a level amount of debt; debt tends to decline or increase. Nevertheless, this state is a “corner point” that a company may turn during its life cycle. This position implies that the company’s cash flows are in balance. The firm does not need additional long-term capital, but it is not yet able to start repaying it.
Such a company is an enviable customer for a financial institution because it requires funds yet should be lowering its risk level with additions to retained earnings. The leverage ratios should be declining. You may even consider increasing its dividend payout to slow the decline in the ratio. Furthermore, if the funding institution needs to reduce the relationship to re-balance its own portfolio, other institutions are likely to find dealing with the customer an attractive opportunity. A company with this characteristic can probably strike a very good deal with its lenders.
Capital position 3
The third stage, increasing debt but declining debt ratios, is characteristic of a company in the late stages of its growth phase or perhaps in the early part of its maturity. The firm still requires additional outside financing but is not exceeding its sustainable rate of growth. The financial markets are still called on for additional long-term debt,and profits are retained in the company to support these requirements. The financial risk is declining as the proportion of debt declines despite its increase in dollar amount. Possibly the nature of the company’s operating risks is also declining as the enterprise attains its natural maturity. Additional financial institutions would probably be willing to help provide funding if an existing source believed it was getting overexposed to one customer.
A firm of this type will typically show a saw-tooth pattern of short-term debt. Short-term debt will gradually increase until it has become large enough to be refunded efficiently with a mortgage or a private placement of long-term debt, probably with an insurance company. At that point, the short-term debt will suddenly drop.
Capital position 4
A company requiring additional debt that increases its debt ratios is either in a strong growth stage or is in a very serious decline. Companies in either of these conditions are challenges for a financial institution because the firm must go to the external equity market to set the ratios right. Other institutions may not be enthusiastic about helping the existing funding sources reduce their position. Even equity investors prefer putting money into new assets rather than toward debt reduction. These preferences require careful planning of a fund-raising sequence for the growing firm. The options for a declining firm are less attractive — sell assets to repay debt.
FINANCIAL MANAGEMENT: Knowing where your company is with respect to its capital requirements is important in dealing with external financial sources. Should you plan for additional debt or plan to repay existing debt? Should you curtail expansion to a level that external sources can support? If you have thought through these issues, you’ ll find (t much easier to deal effectively with the bank or, if necessary, with sources of additional equity.