Liquidity and flexibility. The final area that financial risk measures is flexibility, the ability of a company to withstand fluctuations to deliver results. What are the kind of events that can arise which will test the company's financial flexibility by creating large need for short-term cash? Large debt repayments due either because of refinancing issues or cross-default, material adverse change clauses, missed covenants, et cetera. Dramatic setbacks in the business due to tainted product, viral outbreaks, terrorist attacks, et cetera that decrease customer confidence in the sector or across the globe, or in the case of the COVID-19 global pandemic, the shutdown of entire economies over days and even weeks. Material adverse litigation judgements. Management lapses such as the Volkswagen emission scandal. A desirable acquisition opportunity that comes up. Or a CapEx emergency. The credit analyst needs to understand the sources and uses of liquidity. Liquidity is the most common cause of default. Lack of liquidity can cause defaults in otherwise healthy companies. If we look at a generic cash flow statement we see a company that has generally very healthy cash flows. What if we assume that this company had a debt repayment of 500 to be covered in the current year? How would it do that? Where would we look? We would have to look at the cash to see if they had any cash on hand. We'd have to look at asset sales. We'd have to look at refinancing. In the real world, the refinance risk would hopefully have been addressed by both the current bank lenders as well as the company well in advance of this. Unless the relationship soured, it would be another opportunity for the bank to win business from the client. It is possible this kind of repayment could come up because of a cross default that was triggered somewhere else in the corporate structure, in which case there could be very little warning. Again, this is why we need to understand the sources and uses of liquidity. Where are the sources of liquidity? First, we would look to cash and liquid investments. Next, to forecasted funds from operations. Hopefully it's positive. We would also look for forecast positive changes in working capital. By that, if working capital is decreasing that means it would be a source of cash. Next, we would look for any potential asset sales. Next, we would look at undrawn bank lines that are maturing beyond one year. So in other words, we would not want to draw down on a revolver that is going to be due within a year 'cause it puts us right back in the same situation. We also wanna be very careful that we're not drawing down on a short-term revolver for a long-term financing need. Lastly, we would look to cash injections either from government or shareholders. Cash flow is usually not enough to handle spikes in liquidity needs. Cash flow also happens throughout the year, even though we may be looking at a cash flow statement that shows a nice lump sum at the end of the year. At a point in time a company may not have the kind of cash flow to cover a spike. Higher rated credits do have cash cushions especially those that are aware of not just cyclicality and seasonality, but cash crunches. But lower rated companies and smaller companies simply do not have the cash on hand. Cash or shareholder injections are common, but they're tricky. The U.S. government bailed out the auto industry during the 2008-2009 crisis. Warren Buffett bailed out Goldman Sachs with a preferred equity stake. These take time, so they're usually done privately like the Buffett stake, as opposed to going through the primary markets. In terms of uses, we should have a good sense of the forecast numbers before making a loan. Hopefully, there isn't a forecasted negative funds from operations. But again, if there is a disruption for whatever reason it's very possible that funds from operation could swing negative for one or possibly more quarters. We also have to look at what is the expected CapEx. We have to look for forecasted negative changes in working capital so if working capital is expected to go up that would be, again, a use of cash. We need to understand what the debt maturities are, as well as any guarantees at the JV or affiliate level. We need to understand if there are any pension benefit requirements. We need to be aware of any credit notching downgrades. We need to be aware of any contractual acquisitions. And lastly, we need to know if there are any shareholder distributions that potentially could arise under a stress scenario. S&P uses these sources and uses to create their own liquidity ratio. If sources to uses or sources overuses is 1.2 or greater, that is considered adequate liquidity and up. Anything below is reason for concern. Moody's does not have as clear cut a ratio, but it does look at liquidity in a similar way. Some other common liquidity ratios are current ratio which is basically a total current assets over total current liabilities. Ideally, this is greater than one, meaning that the company can cover its short-term liabilities with short-term assets. The quick ratio is slightly more conservative than the current ratio. It excludes inventories, which are seen as less probable in terms of cash and also prepaid assets because those are generally situations where the company cannot get its money back. It then looks at those assets over total current liabilities as well. The cash ratio is even more conservative. For the numerator we only look at cash and cash equivalents and then put those assets over the total current liabilities. Since these ratios are more limited in scope than the S&P liquidity ratio, what's more important here than a threshold is to compare the ratios to other companies within the industry.
