Manufacturing Articles
Real Solutions for Hockey Stick Projections
Author: Chris Porter
Date: February 2011
Publication: Canadian PLANT
Business owners are inherently optimistic. “Our markets will expand.” “That big order will come in.” “Our profits will rise.”
Many of the optimists were proved right following the global recession. Canadian companies that had low debt loads and cash on hand quickly bounced back. Overall business bankruptcies fell 32% from Q3 2009 to Q3 2010. For the manufacturing sector, bankruptcies fell even further – a whopping 43.2%1.
Among the businesses that did not recover as quickly, owners may have been unrealistically optimistic about the prospects for their enterprises. Accountants even have a term for it: hockey stick projections. This refers to management’s overly optimistic revenue projections (forecasts of dramatically rising earnings after a period of flat or negative growth). Banking on these types of projections may account for some of the 470 bankruptcies and 133 proposals filed by businesses between the end of September 2009 and September 20101.
Liquidating a business, however, is the last option most manufacturers would choose in order to resolve financial difficulties. Currently, manufacturing assets are not selling at a premium and liquidation typically leaves little or nothing for shareholders. There are three more palatable solutions for companies experiencing financial challenges.
First, it’s necessary to identify the source of the difficulties. Problems typically impact either the balance sheet or the income statement.
Balance sheet – for example:
- overleveraging or too much debt for the size of business;
- cost overruns, generally related to an expansion or relocation; or
- high levels of bad debts, which could be caused by the failure of one or more
major customers.
Income statement – for example:
- declining revenue due to customer attrition or new competition;
- outdated technology, resulting in lower efficiency than competitors;
- litigation, which is costly and a distraction for management;
- declining profit margins;
- loss of favourable customer status, discounts or payment terms;
- increase in raw material prices that cannot be passed on; or
- significant management change, resulting in loss of efficiency.
Once the problems have been identified, the question becomes, “can they be fixed while maintaining a viable business?” This can be challenging for owners to answer because of their inherent optimism about their enterprise. The opinion of a professional advisor can help to avoid unrealistic hockey stick projections, which are unpopular with lenders and viewed with skepticism by investors. It’s important to seek an expert, objective opinion as to whether, for example, eliminating unprofitable parts of the business and streamlining operations would position the company to continue successfully.
If the answer is “yes,” there are, broadly speaking, three options.
1. Refinance
Refinancing can strengthen the balance sheet and revive the confidence of management, customers and suppliers. It’s best to try to work with a company’s existing lenders since they know the organization and will likely be the least expensive option. Canada’s 22 Schedule 1 banks2 are generally the best choices for operating loans. While they tend to lend based only on predictable cash flow and extensive security, they charge less than other lenders.
If the company is in an unfavourable situation, it may be necessary to seek additional or replacement financing. Fortunately, many secondary lenders have returned to the market.
- Asset based lenders may be willing to finance a company experiencing financial problems provided it has unencumbered assets and can meet reporting requirements. While these lenders charge higher fees than the banks and have more stringent monitoring requirements, they may advance more funds and be more flexible with companies in transition.
- Factoring companies, which lend against accounts receivable, are helpful in situations where smaller amounts are required or an asset-based lender is not practical. While interest charges and fees are higher, they can quickly turn accounts receivable into cash and will advance greater amounts than other lenders.
- Mezzanine lenders offer a combination of subordinated debt and equity. They typically charge higher interest and incorporate options to convert outstanding debt to equity.
- There are also lenders who will provide senior stretch or over-advance loans comprising a blend of asset-based and cash flow loans. They tend to support manufacturers having a solid asset base but lacking stable or predictable cash flow.
Inevitably, refinancing will likely be more expensive and may require additional security such as personal guarantees. As well, these refinancing options are only available to a manufacturer that can demonstrate – with realistic projections – its ability to repay the loan.
2. Restructure
“Borrowing a little more money” may not resolve all of the challenges a manufacturer faces. The company may need to correct underlying problems by selling portions of the business or by reorganizing or reducing operations.
If there is insufficient time or money to complete a restructuring, or there are a number of contentious issues, or numerous disgruntled creditors, it may be necessary to file a notice of intention to make a proposal (NOI) or to make a filing under the Companies’ Creditors Arrangements Act. (CCAA)
A proposal is akin to a simplified CCAA. Because the rules are more “cut and dried,” professional fees for a proposal are less than those for a CCAA. Typically, a proposal extends an offer to creditors asking them to accept less than the amount owed to them and/or an extension of time to repay debts. A proposal trustee helps to structure and administer a proposal that will be accepted by the creditors and that the company is able to carry out. This compromise can enable a manufacturer to restructure while continuing to operate.
3. Sell
Another solution to financial troubles may be to sell all or a portion of the business before a lender calls in a loan. On the down side, this adds significant time pressure to complete the transaction. As well, prospective buyers will be aware that the company is experiencing financial troubles. While these issues will affect the price and the structure of the deal, moving all or part of the business to new ownership may preserve value.
Formal insolvency strategies may also help to reduce debt obligations and provide more flexibility in completing a sale. Filing for protection under the CCAA or filing an NOI, for example, may delay creditor action while appointing a receiver can help to complete the negotiated transaction when it is necessary to clean the balance sheet or address a potential Bulk Sales Act issue.
The success of this solution, as with the others, relies on acting quickly and providing management with an opportunity to resolve fundamental issues.
Management teams that are successful in refinancing, restructuring or selling tend to be those that use timely, detailed financial information to produce realistically optimistic projections. After all, hockey sticks don’t win financial competitions, they only win hockey games.
Christopher Porter, MBA, CA-CIRP, is a vice-president in the transaction advisory services and financial restructuring practice of BDO Canada Limited (www.bdo.ca). You can reach him at (416) 369-3062 or cporter@bdo.ca.
