Introduction to Credit Management

The optimal debt/equity ratio depends on many variables like capital costs of other companies in the industry, the access for further debt financing and the stability of earnings. Another important measure for the company’s financial situation which can be drawn from the balance sheet is the working capital need, defined as the difference between current assets and current liabilities. Working capital must be related to other financial statement elements such as sales or total. The management of working capital is important for cash flows because it shows how efficiently a company manages its cash. It is defined as:

Working capital = Accounts receivable + inventory – accounts payable.

The amount of cash, marketable securities and noncore assets help to assess the liquidity situation and the financial flexibility of the company as well.

Property, Plant and Equipment are of particular interest to bondholders in case of financial distress, because the proceeds from asset sales are used to service the debt obligations.

Pension liabilities are an important topic in the analysis of corporate balance sheets and hence play an important role in the evaluation of corporate bonds. The two main pension schemes are:

• Defined contribution: the employer pays into a designated pension fund for the benefit of the employee. After the contribution the employer has no further obligation to the employee.
• Defined benefit: the employer agrees to pay to the employee an annuity (or lump sum) of a defined amount at retirement. This pension represents an ongoing liability for the employer.

The evaluation of a company’s future prospects of being a profitable business and the ability and willingness to improve the financial risk profile is a very important part in the investment decision process. The quality and experience of management is of particular interest because the compatibility of the business strategy with the financial profile of a company is fundamental for successful companies. Financial and nonfinancial factors like strategic management decisions (feasibility of the business plan) and the competitive environment set the parameters for the improvement of credit quality in the future. Management has always the option to surprise market participants with the announcement of unexpected company actions which will alter the capital structure. The change of a previously announced strategy is a major component of the event risk. It is impossible to quantify event risk for a company hence it is a subjective factor in the valuation process.

Typical examples are:

• Mergers and Acquisitions
• Share buyback programs
• Focus on new business segments
• Leveraged Buy-outs
• All actions which result in an increased leverage.

Unfortunately, with equity culture so widespread, the tech wreck destroyed far more than a few hundred ridiculously priced tech stocks. All those investors and companies sucked in by jealousy, envy, and regret were hurt. So too were nonparticipants. Regions of the country dropped into recession.

Individuals with no savings lost their jobs. At least the Internet millionaires had homes and cars they could sell for cash until they found new professions.

All bull markets create the belief that stocks are a sure road to high profits. The 1990s bull market added the notion that though there will be ups and downs, in the long term, stocks always beat all other asset classes; In fact, everyone can have free money if they just buy stocks and hold on. The certainty with which this notion has been espoused has prevented investors from hearing a quiet inner voice. That little voice has been whispering for a long time: This cannot go on forever; a price must be paid for all these riches.

Stocks are the 800-pound gorilla of the investment world. Once you agree to dance with the gorilla, the dance is not over until the gorilla says it is. Freeing yourself from the equity culture is very difficult. Stock investors need to consider whether they have the ability to adapt to other investment classes if equities fail to produce positive returns.

In the United States, financial institutions have succeeded in imposing stocks into the culture as the primary investment for the long-term. Legislatures have gone along to coddle voters. IRAs, 40l(k)s, and other tax-favored schemes can only be funded with stocks, bonds, and mutual funds; real estate, gold, and most other asset classes are not allowed. In the 1990s, the number of stock investors and the trading on stock exchanges tripled. There are many dark sides to this besides the fact that there is no conclusive proof that stocks will be the best investment in the future. Equity culture breeds stock jealousy, envy, and regret, which in turn create social tension and recessions. The recent tech boom and bust is one example.

During the tech bubble, many stock investors were jealous of the young entrepreneurs who, through IPOs, became instant millionaires. Many investors envied the employees who received stock options, rather than having to buy stock on the open market. Other investors regretted that they failed to buy the IPOs that doubled, tripled, and quadrupled. In a small asset class, with few investors, another’s success becomes an inspiration rather than a regret. In stocks, these emotions churned up a fever to get in on the action. Businesses that serviced the new economy were so envious that they began to accept stock as payment for services rather than cash.

Hardworking employees quit their jobs and became day traders. Companies paying good salaries added stock options to their compensation packages to retain envious employees. Insatiable investors agreed to pay exorbitant commissions and make unnecessary trades in exchange for a few IPO shares.