Solvency and liquidity.
Two closely related financial terms, dealing with a company’s ability to pay one’s
debts, in the short or in the long term.
To understand solvency, we must first understand its opposite: insolvency.
To understand liquidity, we must first understand its opposite: illiquidity.
Simply put: to be broke, or not to be broke, that is the question!
The solvency, insolvency, liquidity, illiquidity discussion all revolves around the accounting
equation: assets equal liabilities plus equity.
Here’s a useful metaphor to understand how the terms relate.
The glass on the left containing clear water represents assets.
The glass on the right with the red liquid represents liabilities.
Assets are bigger than liabilities.
If we pour out the same amount of liquid from both glasses, bringing liabilities to zero,
we still have enough assets left.
This situation we call solvency.
In the second situation, the assets are once again bigger than the liabilities, but the
nature of the assets is different.
The water, representing the assets, is frozen.
If we had to pour out the same amount of liquid from both glasses, trying to bring liabilities
to zero, we would currently fail, as the assets are not liquid.
This situation is called lack of liquidity, or illiquidity.
We need to get the water to melt.
In finance terms, liquid assets are things like cash, receivables and inventory.
Non-liquid assets are property, plant and equipment, goodwill and other intangible assets.
In essence, there is solvency (possession of assets in excess of liabilities), but no liquidity.
In the third situation, the assets are smaller than the liabilities.
If we pour out the same amount of liquid from both glasses, trying to bring liabilities
to zero, we’d run out of assets first.
This is insolvency: being unable to pay the money owed on time.
At this point, whether or not the assets are liquid or not doesn’t matter all that much anymore.
To illustrate solvency and liquidity in the corporate world, we’ll take a look at the
story of JC Penney, an American department store chain.
When the company filed for bankruptcy reorganization in May 2020, some headlines suggested that
“the pandemic claims another retailer”.
In my view, the company had been very fragile for a long time, and the pandemic pushed it
over the edge.
Even without the pandemic, I am not sure the company would have survived.
JC Penney is an interesting case study in terms of corporate strategy, and retail management.
Penney has been struggling for a long time to remain relevant in an era when Americans
are buying more online or from discounters.
In this discussion, we’ll focus on the financial outcomes of the company’s strategy and operations.
Here’s an overview of the share price over the last few decades, which gives an indication
of investor optimism or pessimism about the company’s actual financial results and the
expected future results.
In October 2006, the stock was trading above $80.
Then came a very sharp drop at the start of the financial crisis.
From 2009 through 2011, the stock traded between $20 and $35,
then around $10 from 2013 through
2016, and sliding lower and lower after that to penny stock levels.
So why did investors lose hope?
We will look at the income statement, cash flow statement, and balance sheet of JC Penney,
as well as several financial ratios, to see if we can spot (with the benefit of hindsight)
that the company was heading towards insolvency.
Here’s how total net sales (in billions of dollars) developed over the years: $20
billion in 2006, shrinking to $12 billion in 2013, recovering slightly, and then dropping
below $11 billion in 2019.
Revenue growth is generally an indicator of financial health of a company, revenue decline
an indicator of the opposite.
Another financial indicator from the income statement: net income, or net profit.
More than $1 billion in 2006 and 2007, but negative (in other words loss-making) or zero
starting in 2011.
Not hugely loss-making every year (that only applies to 2012 and 2013), but steadily slightly
under the black line.
A positive net income is generally an indicator of financial health of a company, making losses
an indicator of the opposite.
The return on sales ratio relates profitability to sales.
How much net profit do you make relative to every $1 of revenue?
Similar story as the curve of absolute net income: zero or negative starting in 2011.
Positive and increasing return on sales is an indicator of financial health of company,
negative and decreasing margins an indicator of the opposite.
Profit is an opinion, cash is a reality.
Let’s turn to the cash flow statement.
This is the graph of Cash From Operating Activities (or CFOA), the cash flow related to day-to-day
operations, basically what customers pay the company in cash, minus what the company pays
in cash to employees, suppliers and other such creditors.
Only one really negative year: 2013!
In the other years the company is generating some Cash From Operating Activities, although
not an enormously exciting amount.
If you take this Cash From Operating Activities, and deduct the company’s capital expenditures,
you get to one of the most meaningful financial metrics of a company: Free Cash Flow.
Free Cash Flow is that part of the total cash flow that is not required for operations or
reinvestment, in other words that part of the cash flow you could take out of the company
(to pay down debt, pay a dividend to shareholders, or do share buybacks) without hurting its
ongoing operational capability to pay the bills, and without hurting the investment plan.
A similar curve as net income and CFOA: doing relatively OK until 2011 (in those years the
company could afford to pay a dividend to shareholders, and buy back shares!), very
negative performance in 2013, and then a stable performance around zero for the years thereafter.
A simple rule of thumb from the world of valuation: no Free Cash Flow, no value!
Not having any Free Cash Flow for years, and no hope for positive Free Cash Flow in the
future, drives a company’s share price down, ultimately to zero.
The balance sheet.
Assets equal liabilities plus equity.
Assets in blue, liabilities in red, equity in green.
As we saw in the income statement, the company has been shrinking in revenue.
We also see a shrinkage on the balance sheet: assets were $14 billion in 2007, and just
$8 billion in 2019.
Liabilities in absolute terms have not been growing over the years, staying fairly stable.
Equity, the book value of the shareholder capital, has eroded more and more, mostly
due to the loss-making situation the company has been in for years.
From over $5 billion of equity to $1 billion.
As equity is the “buffer” against bankruptcy, you can see how fragile the company’s situation
is by the end of 2019.
This is expressed very clearly in a solvency metric called the debt-to-equity ratio.
To keep things simple, I have taken the total liabilities and divided them by the total equity.
The higher the debt-to-equity ratio, the higher the financial leverage.
The debt-to-equity ratio has exploded over the years!
By 2019, for every $ of equity, there were $9 of liabilities.
If you look at a key liquidity metric called the current ratio (current assets versus current
liabilities), you see a gradual decline, but not a dramatic warning sign.
In general, a current ratio above 1 is generally viewed as healthy.
Another symptom of the fragile situation the company already was in before the pandemic:
JC Penney’s share price in the twelve months before filing for bankruptcy.
On August 6, 2019, JC Penney received notice from the New York Stock Exchange that it is
no longer in compliance with NYSE continued listing criteria … which require listed
companies to maintain an average closing share price of at least $1 over a period of 30 consecutive
trading days.
According to the rules, the company had a period of six months to regain compliance
with the minimum share price requirement, either by the share price rising above $1
again and staying there, or by the company executing a reverse stock split.
On December 2nd, 2019, JCP received notice from the NYSE that it has regained compliance
with minimum average share price requirement.
The Company regained compliance after its closing share price on November 29, 2019 and
its average closing share price for the consecutive 30-days of trading prior to that date were
both above $1.00 per share.
In early 2020, the share price went South again.
On January 31st, 2020, JCP received notice from the New York Stock Exchange that it is
no longer in compliance with NYSE continued listing criteria.
This time, it would not re-emerge.
On April 15, the company filed a statement that it elected not to make the approximately
$12 million interest payment due and payable on April 15, 2020,
and entered into a 30-day grace period to make the Interest Payment
before such non-payment constitutes an “event of default”.
One month later, on May 15, the company filed for bankruptcy, with the intent to reorganize.
So filing for bankruptcy does not necessarily mean that a company will liquidate!
There may be plans, like in the case of JC Penney, to reorganize and restart.
As a consequence, the day after filing for bankruptcy, the New York Stock Exchange commenced
proceedings to delist JCP’s common stock.
On May 18th, the NYSE suspended trading in the Company’s common stock, and subsequently
trading moved to OTC Pink under the symbol “JCPNQ.”
What’s next (at the time of making this video, just after the bankruptcy filing)?
JC Penney and its creditors entered into a Restructuring Support Agreement, with the
intention to establish both a financially sustainable operating company (“New JCP”)
and a real estate investment trust.
The contemplated restructuring process includes the issuance of New JCP common stock.
So “the end” may not necessarily be “The End”!
Zooming out from this specific case study,
it’s important to ask the question “Insolvency…. now what?”.
More specifically: to liquidate, or to restructure… that is the question!
Let’s walk through a simplified example of both.
Let’s say a hypothetical company has assets of $8 billion, liabilities of $9 billion,
and negative equity of $1 billion, in other words it is insolvent with a negative net worth.
The “old” shareholders have already lost their investment, their shares become void.
Liquidation means selling off the assets, probably for less than their book value.
The creditors have to write off part of their claim on the company’s assets as a result.
You can then use the $6 billion in cash you generated from liquidating the assets to pay
off $6 billion of liabilities.
Alternatively, you could walk the path of restructuring.
Same starting situation: a hypothetical company has assets of $8 billion, liabilities of $9
billion, negative equity of $1 billion, insolvent with a negative net worth.
Write down part of the liabilities, and issue equity to the creditors.
The reorganized company could continue operations with a recapitalized balance sheet.
To understand solvency, we must first understand its opposite: insolvency.
To understand liquidity, we must first understand its opposite: illiquidity.