When a business is too indebted

Simon Brown, founder and director of JustOneLap.com.
Simon Brown, founder and director of JustOneLap.com.

They say a banker lends you an umbrella when it’s sunny and then wants it back when it’s raining. But this cliché isn’t really fair. Bankers often come in at the worst time in a company’s life, having to try and save it. 

Sure, they’re protecting their own business interest – in most cases loan advances. Let’s be fair, protecting their business interest is not a bad thing. If they didn’t, the company and the bankers would go out of business and there would be no bankers left to lend us money.

Currently, many locally listed stocks are getting into trouble with debt and breaching their debt covenants. These covenants are essentially conditions imposed at the time of the loan and require certain financial ratios be maintained, otherwise the debt is in breach. 

In good times, covenants are no problem. But when things go south, they become a real problem for both lenders and borrowers.

While a covenant breach means a debt can be recalled immediately, this seldom happens. When debt is recalled, the company is likely to go bankrupt, and the lender would get very little (or nothing) back. Therefore, with covenant breaches, bankers often pretty much take over the finances of the company, certainly the bigger picture issues like asset sales and raising cash to reduce debt.

You don’t want bankers running the business; they’re not necessarily experts in a specific sector. But they are experts in debt, refinancing and other issues critical to the survival of the business. They know how to restructure loans and generally keep the business afloat while waiting for trading conditions to improve. 

Bankers won’t gut the business purely for their own gain. (Where there have been claims of this, criminal proceedings should follow.)

Similarly, large shareholders often put serious money in via a rights issue aimed at saving the business. The claim is that they’re throwing good money after bad. But they’re also trying to save their original investment by keeping the business alive.

Bankers try to protect the business and get it profitable so that they can get the loan(s) repaid. But a few important questions must be asked. Will they succeed? Why did the business reach such a critical state? Can management be trusted to not almost bankrupt the business a second time after the bankers have ‘repaired’ it?

A company going bankrupt will always be the last resort. But even a ‘saved’ company will struggle to regain market trust. Yes, the business has been kept afloat, but at what cost to the business and, ultimately, shareholders?

So, while a stock you own may be saved – and that’s great – it is no longer a great investment. You’re better off exiting and finding a great investment.

This article originally appeared in the 15 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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