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Watch for financial distress signs before it's too late: analysts
A RECENT slew of debt defaults and attempts to stave them off among Singapore-listed companies in the offshore-and-marine (O&M) sector has spooked investors and sparked a bout of soul-searching on whether SOS signals could have been spotted earlier.
By the time companies become insolvent, it is typically too late for investors' portfolios. To avoid being trapped on a sinking ship, there are some key financial indicators investors should watch especially closely, analysts suggest.
Others add that the warning signs of impending financial distress might be spotted even before it manifests itself in the form of illiquidity or worse, if investors pay careful attention to cash flow trends and non-financial indicators such as industry conditions.
Key financial metrics that can throw up red flags for investors across multiple sectors are those that relate particularly to the company's ability to service its borrowings, which may be deduced from its liquidity, interest coverage, gearing levels and debt profile, market observers say.
"Generically key for us is cash flow related to the composition of the balance sheet - crudely relating the profit-and-loss account to the overall capital position," says Aberdeen Asset Management Asia managing director Hugh Young.
"Details would include the term of the debt (long-term lock-in or short-term rolling at the extremes), covenants, etc. Currencies also play their part, and often distress arises when a business is mismatched from a currency point of view internally."
Lee Wen Ching, equity analyst in the chief investment office at private bank UBS Wealth Management, says the three most relevant financial indicators of impending distress are a company's ability to pay interest on its outstanding debt, or interest coverage; the ratio of its cash to short-term debt, which indicates liquidity; and its gearing level, in terms of debt over the company's earnings before interest, tax, depreciation and amortisation (Ebitda).
"These metrics are relevant leading indicators because the financial metrics deteriorate over time, before the company becomes insolvent."
NRA Capital research head Liu Jinshu says that investors can look at earnings growth and cash flow trends. If earnings growth is "constantly negative", for instance, the equity base is being chipped away, and sectors with negative earnings growth are "hotspots for financial distress", he says. "By the time you see it (distress) in the balance sheet, it's too late already."
Analysts note certain sectors may have relatively more obvious leading indicators, and some non-financial metrics may be equally or more effective in detecting danger earlier on.
"Indicators of current or, more importantly, future distress are not solely related to financials," says Andrew Wong, credit analyst at OCBC Bank.
"The first things to consider are business indicators related to the company's operating environment and the company's business model. This is because the operating environment (framed by its country and industry exposure) and the strength of the company's position within its operating environment will have a direct impact on the profitability and cash flow generation (that is, financial indicators) of the company."
He notes that in the case of the O&M sector, "while stress within the sector accelerated to an extent in Q3 2016, judging by the number of restructurings/defaults, the operating environment was coming under pressure as far back as Q4 2014, when oil prices plunged".
"This was perhaps the earliest sign of eventual stress, although at the time it was hard to see for how long oil prices would stay weak."
Mr Young adds that for commodities businesses in general, commodity prices "are vital . . . this is where stress can be quickly evident, as we've seen in capital-intensive businesses with debt where cash flow dries up - oil-and-gas exploration; rig builders".
"A deeper layer of detail is then composition of the book of business - for example, heavy reliance on a single customer, say, Petrobras."
Commodity prices may indirectly affect various other sectors, such as banking, in the form of non-performing loans (NPLs), he adds.
"(The) size of book in exposed sectors such as commodities is something we look at closely. NPLs at banks typically occur after it's clear a sector is in trouble. So they're a lagging indicator. Thus, in theory, while one could argue - I don't by the way - that the worst is over in the energy sector, you'll still be seeing NPLs coming through," Mr Young says.
Mr Liu of NRA Capital says that for industrial sector stocks, investors should be wary of lengthening cash conversion cycles combined with declining profitability.