Businesses are cash-short, and the cash squeeze will intensify as more and more firms encounter an abrupt drop in revenues. Several companies have already been forced to draw on their credit lines, and the decision to draw down credit facilities will grow in scale and numbers. Firms weak capital structure will deepen the recession and dampen the recovery.
At the end of 2019, nonfinancial companies had 70 cents of financial assets for every $1 of liabilities. That is at the low end of the historical range of financial assets coverage of total liabilities, and well below the levels of the past two recessions.
Even more troubling is the thin holdings of highly liquid financial assets relative to liabilities. Financial assets such as time deposits, equities, and mutual funds all have a liquidity dimension comparable to other highly liquid assets (cash and checkable deposits) as they can be converted quickly into cash the next business day or two.
In Q4 2019, nonfinancial companies holdings of highly liquid financial assets covered only 30 cents of every $1 of liability. That razor-thin coverage is equivalent to what nonfinancial firms had on their balance sheet at the end of the Great Financial Recession and is a fraction away from an all-time low.
If a modest “haircut” were assessed against equities and mutual funds, due to the drop in the stock market since the start of 2020, the ratio of highly liquid assets to total liabilities would currently stand at an all-time low.
How did companies get into this precarious financial position?
In the past decade, the attraction of very low-interest rates encouraged, if not incentivized, firms to increase leverage. Since 2010, nonfinancial firms outstanding debt and loans has nearly doubled to $10.1 trillion.
Also, the change in tax law in 2017, which resulted in a sharp drop in corporate tax rates, freed up large sums of cash flow and companies decided to use the “windfall” to buy back stock, instead of boosting its liquidity buffers.
Nonfinancial companies would have greater levels of liquidity if they didn't decide to use leverage and tax benefits to buy back stocks. So the illiquidity of companies and the unbalanced capital structure is self-imposed.
The 2020 fiscal aid package passed by Congress will help ease some, not all, of the liquidity strains of companies. Businesses with 500 or fewer employees will be able to get direct loans to cover payrolls and other operating expenses for up to 6 months. The government also plans to directly inject capital into several large companies.
The delay of 3 months of mandated federal tax payments due on April 15 would also reduce the near-term drain on cash. The Federal Reserve and Treasury were also given the authority to extend loans to companies.
The idea that the federal government can extend credit to companies with a weak and unbalanced capital structure and suddenly turnaround the prospects of firms makes no sense. Corporate turnarounds require an improvement in operational efficiency (i.e., lower costs) and in many cases a reworked capital structure. Adding more debt is the exact opposite of what is needed.
On the other side of the coronavirus crisis will be the realization that many firms operated with the wrong capital structure; too much debt and too little cash. As a result, investors should expect a protracted corporate deleveraging cycle along with a “weeding out process” (i.e., firm failures) that will together dampen the economy’s growth prospects for an extended period.