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Morning Column
Dealing with a credit crunch: How to navigate through economic challenge
By Jeremy Kroll CA•CIRP
It's hard to make sense of today's economic headlines. On the one hand, as recently as April, Reuters reported that the Royal Bank of Canada was seeing little indication of slowing growth, even in mortgages. As evidence, RBC pointed to stable employment statistics, low interest rates, relatively affordable housing and Canada's mortgage loan-to-value ratios, which tend to be more conservative than their U.S. counterparts.
Yet the reality of many consumers and businesses seems to negate this evidence. After years of economic prosperity, many consumers and businesses are now facing a credit crunch. Some financial institutions have pulled out of short-term lending. Others are posting significant losses, which is putting pressure on lending practices. Small businesses and consumers appear to be among the first to feel the pain.
According to Industry Canada, consumer bankruptcies rose by 3.8% between June 2007 and June 2008. While business bankruptcies declined slightly for the same period, corporate proposals for financial relief rose by 7.6%. At the same time, organizations in industries as diverse as manufacturing, retail and automotive services are experiencing ongoing layoffs and closures.
As with previous periods of economic volatility, some organizations will be harder hit than others. The trick for navigating through these challenging times will depend on how quickly you respond to any signs of distress.
Heeding the warning signs
For small businesses - and their owners - it makes sense to start by reviewing your balance sheets and portfolios to determine if any trouble is on the horizon. To avoid crisis, it's important to both pinpoint your current areas of strength and weakness and identify where you stand on the credit crunch curve.
Early warning signs of distress may include shrinking profit margins, an eroding customer base or a noticeable reduction in working capital or cash flows. Acting quickly to mitigate challenges at this stage can leave you with a wider range of options than if you ignore these signals.
As financial challenges escalate, however, the warning signs are harder to ignore. Signals of later stages of distress may include an ongoing decline in market share, steadily increasing expenses and expressions of concern from bankers. Companies in grave financial danger may even begin delaying reporting of financial information, breaching bank covenants or defaulting on debt obligations.
The importance of a rapid response
If you're facing financial challenges, the importance of a rapid response cannot be overstated. Organizations with stable cash flows have more options available to them during times of need. Depending on your corporate situation, you may have sufficient cash flow to weather today's challenges by adjusting your balance sheet, rationalizing your business services or restructuring your debt portfolio.
For instance, businesses with stable cash flows facing difficulty with traditional lenders can consider non-traditional financing. Start up organizations interested in entering informal lending arrangements may be able to attract capital from angel investors, who are typically high net worth individuals that provide seed capital to companies with solid growth prospects. Venture capital firms may also be willing to provide financing, if you're willing to give up some equity. And private equity firms are often willing to help finance an owner's retirement, a management buyout or a merger or acquisition.
Companies with a decent balance sheet are also better positioned to explore options from a debt perspective. For example, subordinated or junior debt lenders may be willing to provide funding in exchange for an unsecured or lower priority claim against assets or properties already financed by another lender. Similarly, you may qualify for mezzanine debt, a hybrid form of debt and equity.
If you're facing more serious challenges, it may be time to spin off non-performing assets or consider other options for monetizing them. Asset-based lenders often offer a good option in these cases by providing businesses that are undercapitalized, unprofitable or in the process of a turnaround with secured loans against specific business assets.
Surviving volatility
Even if you are already facing a serious cash flow crisis, options remain depending on the size of the company - such as initiating an informal proposal with creditors; a Division 1 Proposal under the Bankruptcy and Insolvency Act (BIA); or in some cases, a Companies' Creditors Arrangement Act (CCAA) reorganization.
An informal proposal is just that - an arrangement made informally by a company with its creditors. Organizations facing a serious financial crisis, or those with numerous creditors, may have difficulty implementing an informal proposal. However, for those that succeed, this route has the advantage of enabling a company to navigate through difficult times without entering formal reorganization proceedings.
Where universal creditor approval is impractical, a Division 1 Proposal or a CCAA reorganization are better alternatives. With a Division 1 Proposal, debtors request their creditors to settle their claims for less than the full amounts owing. If a certain percentage of creditors agree, the company can restructure its balance sheet while reducing its debts. If the creditors reject the proposal, the company is automatically considered bankrupt.
For its part, the CCAA deals with the reorganization of companies that have a minimum of $5,000,000 in total debt. Like a Division 1 Proposal, a CCAA reorganization allows companies to restructure their debt following creditor and court approval. Unlike Division 1 Proposals, however, CCAA proceedings afford greater flexibility to organizations seeking debt protection.
All three options allow companies to retain control over their business during the restructuring process. This balance sheet restructuring can help buy much-needed time for a company to fix the inherent operational problems that caused its financial concerns in the first place. In this way, even faltering companies can get the reprieve they need to develop a more sustainable business model that addresses current economic realities.
Regardless of the actions you're taking, it's critical to talk to your bank and to other restructuring and turnaround specialists to gain a complete understanding of the range of options open to you. By keeping your bank informed of potential signs of distress, you improve the chances of bringing them onside to assist with your restructuring efforts. By working directly with finance professionals, you can enhance the odds of a successful negotiation with your creditors. As a result, the company as a whole will be better able to re-engineer the business for long-term survival.
Jeremy Kroll is a Partner with the Toronto-based firm of A. Farber & Partners Inc., which provides broad based services and advice in the areas of insolvency and restructuring and is part of the Farber Financial Group. Other specialty services provided by the Farber Financial Group include forensic accounting, fraud investigations, corporate finance, turnarounds and CFO resources.
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