With the initial storm having subsided slightly, global companies are coming to grips with the fact that exiting the storm is going to take a little longer than anticipated. Local companies are realising that the worst may not be over, and that the aftermath may have damaging consequences.
South Africa is seeing the consequences of its recession, a word last used with any real meaning in South Africa some seventeen years ago. The aftermath will remain a topic of discussion for many months to come. As such, there are many fundamental considerations South African management teams need to consider during this period of difficulty, a few of which are described below.
The changing landscape
South Africa was generally unscathed at the onset of the global credit crisis, having had limited exposure to toxic sub-prime debt instruments that originated in the US and poisoned the economies of both Europe and the US. However, with continued liquidity concerns, there has been an extended negative impact on businesses, with demand, and consequently jobs, drying up in certain sectors at a rapid rate.
The changes we see today would never have been expected a year ago. This is evidenced by the trillion dollar government bailouts seen around the world, and the governments of first world countries now owning not only most of the mortgage loans in their individual countries, but also some of the largest financial institutions in the world. We have even recently witnessed the accounting standard setters (the International Accounting Standards Board, which issues IFRSs) give in to politicians for the first time to provide some relief from “further losses” as a result of the turmoil, by allowing reclassifications of certain financial assets to minimise volatility in financial statements. The IASB agenda has also changed significantly over the last few months to allow for recommendations by the G20, regulators and other groups.
Impact on existing debt
Many companies in South Africa and globally have gone through a phase of increasing debt over the past years, in order to capitalise on growth opportunities. In the light of the current squeeze on liquidity, these companies may be grateful for having obtained financing at an early stage. However, management need to not only know how that debt was structured, but also need to continue to ensure that any changes to the variables inherent in the debt do not result in increased interest payments and therefore additional outflows of cash.
Guarantees given by holding and sister companies need to be re-evaluated. This is true from the position of the grantor, where the financial position of the holder may be in doubt, as well as from the position of the holder, as the guarantee may also hold less value today than previously assessed.
The reduced availability of credit due to the inability or unwillingness of financial institutions to provide funding, and illiquidity in short-term funding, may have significant adverse consequences for entities; to the extent that a company’s going concern assumption may be impacted. Financial institutions are, in certain cases, imposing very stringent requirements when companies are negotiating or renegotiating finance.
Customers and suppliers
Another area for consideration is the ability of customers to repay debts as they become due, given the dual blow of decreased recoveries from debtors, and suppliers pushing for payment. Companies should begin by looking at which of their customers have been affected and when amounts owing by them will be repaid. It is more important than ever to have a good relationship with both suppliers and customers and to understand what is happening in their businesses as these may have a fundamental impact on the ability of the respective companies to trade in the future.
Companies in South Africa and globally have provided detailed liquidity risk management disclosures and sensitivity analyses under IFRSs in their financial statements. Although this disclosure is but a snapshot and not a forecast, the information provided by companies will certainly be an area of focus. Management needs to make sure that the information given to the market through IFRSs in respect of liquidity risk, credit risk and market risk is adequately stress tested.
Impairment of non-financial assets
The impairment of financial assets has certainly been an area of attention in the last few months. This attention is now moving towards non-financial assets. Careful consideration should be given to long-term non-financial assets (principally goodwill, PPE and intangibles). The significant M&A activity prior to the economic downturn may well have resulted in large amounts of goodwill and intangible assets being recognised in the acquiring entities’ balance sheets. The economic downturn has impacted certain impairment calculations in several different ways, most notably: triggering impairment reviews, affecting key assumptions underlying management’s cash flow forecasts (growth, discount rates) and requiring more sensitivity disclosures.
There are two main considerations regarding pension accounting under IFRS which need to be understood carefully in this market: firstly, determining the appropriate discount rate; and secondly, establishing the fair value of plan assets. The current financial crisis warrants that these should both be carefully considered at reporting date, particularly as many of these funds may have had recorded surpluses prior to the global financial crisis, and deficits may now start to appear.
Share based payments
The parameter that most impacts the fair value of share options is the assumption regarding future share price volatility. Current market conditions mean that observed present volatility is much greater than it has been for some years. Difficulty therefore exists in estimating what share price volatility might be over future periods. In calculating this share price volatility, the guidance in IFRS suggests that it may be acceptable to ignore temporary periods of exceptional volatility caused by some specific event that will not be repeated. This is acceptable only for an event specific to the entity, not volatility in the market as a whole. An entity that has used implied volatility to determine its assumptions may find that current market conditions may mean that the anticipated volatility over the next twelve months is greater than over the next five years. This approach may therefore no longer be valid and should be reconsidered.
Companies should also give careful consideration to dividend yield assumptions. If the assumed dividend yield is significantly greater than the risk-free rate, this increases the sensitivity of an option valuation model to the volatility assumption and reduces its sensitivity to the increases in the expected life assumption.
Depending on the share based plan of a company, these considerations together with certain modifications to the plan (including cancellations), may impact the company’s profits significantly, in particular where the IFRS 2 charge is accelerated.
Entities should evaluate the recoverability of all or a portion of their deferred tax assets in the current economic environment, particularly when current and expected future profits have been adversely affected by market conditions. Some deferred tax assets previously recognised by companies may no longer be recognised due to a lack of recoverability.
M&A Activity and capital expenditure
Companies embarking on capital expansion programmes and merger and acquisition activity are rethinking how these activities impact their strategy in the current market. Acquisitions have seen a slowdown, as many companies feel that the lost opportunity of a successful acquisition is a small price to pay compared to the perceived risk-taking in a choppy economic environment. With tighter credit terms, interest expenditure and projected decreased demand in some sectors, many companies are reconsidering the likely profitability of planned capital expenditures. However, companies would be well advised to be on the look out for cheap acquisitions, where underlying value may exist, provided they can obtain the financing for the transaction.
Matters for boards to consider
In managing these and other risks, boards should consider if their risk management procedures are adequate to identify and evaluate all risks and exposures across the group. Whilst management at head office or group level may be aware of the situation and key risks, it is equally important to ensure that management at other levels within the group are adequately armed and aware of the matters that group management are considering. Information is a vital tool in this unsteady environment.
Directors have a key role to play by determining which areas they should be placing focus on, as the changing economic environment, and crisis, pose challenges at both a strategic and operational level. Boards should be considering:
• how credit rationing impacts key customers and suppliers, and how the company is protected in this regard;
• if there are debt covenants in place that are likely to be triggered in the near future;
• what is the company’s financial sustainability in a credit constrained economy, and how the company’s plans may need to be adjusted;
• to what extent there is dependence on short-term borrowings or other short-term finance, and how the company plans to obtain such borrowings;
• what steps are in place to deal with any funding deficiencies;
• whether or not the financing strategy and capital structure are still adequate in the current environment;
• if there are any assets or businesses that should be impaired;
• having a working capital review performed; and
• what growth opportunities may become available and how the company will grasp these.
It is not all doom and gloom. The current situation allows companies, which are agile, to act effectively on the challenges and thrive in the medium to longer term. Transparency and keeping all stakeholders informed will be a large part of that success. As JF Kennedy pointed out: “When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents opportunity.” Some management teams will be faced with one or the other, and some management teams will be faced with both. Which one is your management team faced with, and have you responded accordingly?
Suresh Kana CA(SA), BCom, BCompt (Hons), MCom, is the CEO of PricewaterhouseCoopers.