RSS FeedBy M. Isi Eromosele
If a company suffers a cash flow shortfall, it is forced to use its liquid assets instead. Nevertheless, to carry such a buffer stock of equity capital is expensive. Through a reduction of risk, a company can lower the buffer stock of equity capital it requires to thrive.
As a result, companies face a tradeoff between equity capital and risk. This tradeoff needs to be quantified, enabling the firm to optimize it.
In a scenario where a company lacks an unlimited buffer stock of equity capital, a drop in the value of the firm leads to a state of affairs where the company will be unable to implement the projects that it needs for growth because of its financial constraints. Financial distress is a conditional circumstance where a firm has to give up positive net present value (NPV) actions because of financial constraints.
There are various degrees of corporate financial distress. For example, if financial distress is moderate, a company will be forced to give up only marginally profitable projects, but not projects requiring large NPVs. As the financial distress increases, the company will finally get to a state of affairs where it is unable to invest in new projects.
Generally, companies should focus on a shortfall level that they can control because exceeding that shortfall level will result in high negative costs for shareholders that would exceed the shortfall itself. For example, if that shortfall level is $200 million, a shortfall of $300 million decreases shareholder wealth by more than $300 million because it also costs the shareholders the loss of positive NPV projects.
Factually, a company cannot guarantee that it would never incur a shortfall that exceeds the threshold it has set for itself. As long as the company earns more than the risk free rate, it has to take the risk of having shortfalls. The company must trade off the probability of large shortfalls and the costs associated with them with the expected gains from taking or retaining risks to optimize its risk portfolio.
The level of resources below which a company is in distress is the financial distress threshold. This threshold would correspond to a level of capital below which the company is in financial distress. It is often instinctive for upper management to think of a bond rating below which the company is in financial distress.
Taking a company’s current rating into consideration, rating agencies data is used to estimate the standard probability of its achieving its desired ratings. Such a probability may be too high for some companies and too low for others.
Ratings are good proxies for estimating a company’s financial health. As such, a company can use a rating agency transition matrix to estimate the amount of capital it would need for a given level of risk. The transition matrix identifies the regularity with which companies are moved from one rating level to another within a specified period of time.
Analysis and management of probability and probability of downgrade should be done in separate and related frameworks. Probability of default is anchored to a company’s target ratings and the corresponding default history. Probability of downgrade is influenced by the management of risk concentrations, such as natural disasters and equity markets.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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