I'm sure everyone has encountered at least one corporation that looks healthy, (with Liquidity ratios, Profitability ratios, Asset management ratios, Debt management ratios, Dividend and market value ratios that paint a picture of vibrancy and soundness) and then, suddenly gets wiped-out in a cyclical business slowdown.
How did that happen?
There is no single correct, or universally applicable capital structure (X percent equity and Y percent debt); infinite optimum variations exist in different industries and economies. Ideally, a corporation's capital structure has to evolve in response to changes in the corporation's micro and macro environment.
A firm with a capital structure that isn't responsive (a firm that's mis-financed) to micro and macro environmental changes, will fail to survive in the long run: If a corporation has the best management in the world, the best market prospects and the wrong capital structure, it will fail to survive in the longterm.
How did that happen?
...It's the capital structure stupid (look beyond the ratios)!
There is no single correct, or universally applicable capital structure (X percent equity and Y percent debt); infinite optimum variations exist in different industries and economies. Ideally, a corporation's capital structure has to evolve in response to changes in the corporation's micro and macro environment.
A firm with a capital structure that isn't responsive (a firm that's mis-financed) to micro and macro environmental changes, will fail to survive in the long run: If a corporation has the best management in the world, the best market prospects and the wrong capital structure, it will fail to survive in the longterm.
...Before we go into identifying a corporation that's mis-financed, how do you identify a firm that's well-financed.
Firstly, you need to have great understanding of the firm, its business model, its competitive environment and the firm's broader; political, economic, social and technological environment. (that's the obvious part)
Then you also need to relate the risk in a firm's capital structure to risks in the firm's micro and macro environment. According to Michael Milken's essay titled, The Corporate Financing Cube; a financially strong firm's risk in capital structure varies inversely with (macro) volatility and risk in the basic business. What does this mean?
This means: as a firm's risk in basic business (and macro volatility) increases the risk in capital structure should decrease in proportion to the environmental risk increase. For example, the management of a firm with a debt to equity ratio of 3:2 (60% debt and 40% equity), which is experiencing the adverse effects of globalization (an increase market volatility) should:
Which reads: risk in capital structure is equal to a constant number divided by the total sum of; macro-volatility and risk in the basic business. Where:
Below is a graphical illustration (according to the above-introduced mathematical expression) of the ideal relationship between risk in the capital structure AND macro volatility and the risk in the basic business.Then you also need to relate the risk in a firm's capital structure to risks in the firm's micro and macro environment. According to Michael Milken's essay titled, The Corporate Financing Cube; a financially strong firm's risk in capital structure varies inversely with (macro) volatility and risk in the basic business. What does this mean?
This means: as a firm's risk in basic business (and macro volatility) increases the risk in capital structure should decrease in proportion to the environmental risk increase. For example, the management of a firm with a debt to equity ratio of 3:2 (60% debt and 40% equity), which is experiencing the adverse effects of globalization (an increase market volatility) should:
- Generally reduce the firm's risk in capital structure by issuing more equity instruments and reducing debt (reducing leverage), to keep the firm financially strong.
Rcs = k / (a + b)
Which reads: risk in capital structure is equal to a constant number divided by the total sum of; macro-volatility and risk in the basic business. Where:
- Rcs represents the risk in capital structure
- k represents a constant number
- a represents macro volatility
- b represents the risk in the basic business
The Ideal scenario: an inverse relationship between capital structure and macro volatility + risk in the basic business
Explanation of the graphical illustration: The graph on top shows an inverse relationship between capital structure and macro volatility + business risk. The vertical axis represents risk in the capital structure. The horizontal axis represents macro volatility plus risk in the basic business. The navy-blue inwardly curving line illustrates an inverse relationship between between capital structure and macro volatility + business risk:- A firm on point a with a risk in capital structure of Rcs 9 and volatility and business risk of V2; is a company that has a stable business model and revenues that are relatively unaffected by cyclical business slowdowns eg. a supermarket. Such a business can be leveraged with the highest debt to equity ratio (in comparison to firm's on points b and c)
- A firm on point c with a risk in capital structure of Rcs 1 and volatility and business risk of V20; is a company with very high business volatility and high competitive risk. It operates in an industry where cashflow is hard to predict e.g. an internet start-up. In such a business, the majority of the capital structure should consist of equity instruments; as it is difficult to predict with certainty if the firm will be able to generate sufficient cashflows to service debt.
Businesses that are mis-financed generally fall into two categories: 1) Businesses that are under-leveraged 2) Businesses that are over-leveraged
Graphical illustration of two dangerous types of mis-financing: over-leveraging and under-leveraging
The explanation of this graphical illustration can be found in the text below:
- Under-leveraged corporations: To identify if a firm is under-leveraged, you have to look at the relationship between the firm's capital structure risk AND macro volatility + risk in the basic business. An under-leveraged firm 's risk in capital structure, has a negative direct relationship to its macro volatility + risk in the basic business. Mathematically this can be expressed as; Rcs = [-k *(a+b)] + c , where Rcs represents the risk in capital structure, k represents a constant number that lies between 0 and 1, a represents macro-volatility, b represents the risk in the basic business and c is a constant number that is greater than 1. In the graphical illustration above, the downwardly sloping red trajectory labeled J represents the relationship between risk in capital structure and macro volatility + risk in the basic business; of an under-leveraged firm. Such a firm usually has an undervalued share-price and has a strong likelihood of failing because of the mis-alignment of management's and shareholder's interests.
- Over-leveraged corporations: To identify if a firm is over-leveraged, you have to look at the relationship between the firm's capital structure risk AND macro volatility + risk in the basic business. An over-leveraged firm's risk in capital structure, has a positive direct relationship to its macro volatility + risk in the basic business. Mathematically this can be expressed as; Rcs = k *(a+b) , where Rcs represents the risk in capital structure, k represents a constant number, a represents macro-volatility and b represents the risk in the basic business. In the graphical illustration above, the upward sloping green trajectory labeled K represents the relationship between risk in capital structure and macro volatility + risk in the basic business; of an over-leveraged firm. Such a firm faces the risk of insolvency and will suffer financially in when a cyclical business slowdown occurs. An over-leveraged company is very weak!
