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Stock Strategist

Firms at Risk for a Shortfall

Morningstar's Cash Flow CushionTM can be used to identify refinancing and liquidity risk.

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The recent financial crisis has underscored the propensity of credit markets to be unpredictable and cost-prohibitive. When assessing a firm's overall financial health, especially firms with weak credit, we think it is important to be able to identify future periods when cash shortfalls and debt refinancing risk are likely to occur. In fact, the very nature of the credit markets at the time when a company may have to refinance debt or shore up liquidity can have profound implications on its likelihood of default as well as on the value of its equity. This is especially true if the firm has no choice but to refinance at materially higher costs, or issue new stock at bargain-basement prices to retire maturing debt.

The Cash Flow CushionTM used in the calculation of Morningstar's corporate credit rating is a measure that takes a firm's excess cash on hand plus adjusted free cash flow generation over the next five years, and divides that sum by the firm's cash contractual commitments over the same time horizon. This measure provides investors with an intermediate-term view of the firm's future path of cash inflows and outflows. It also helps investors to determine if a company's future cash generation will be sufficient to meet its debt-like cash obligations, in aggregate, over a five year period.

Interestingly, the Cash Flow CushionTM can also be broken into annual periods, allowing investors to pinpoint the specific year at which a firm may encounter refinancing risk or a liquidity crunch, based on our analysts' forecasts. Instead of applying cash flow analysis in a five-year snapshot as with the Cash Flow CushionTM, the annual measure compares a company's cash generation to its debt-like cash commitments in each of the next five years. In the year that this annual ratio falls below one, a firm may find itself dependent on refinancing debt or engaging in other means to shore up liquidity, according to our analysts' forecasts.

The table above reveals companies in our current credit rating coverage universe that earned an issuer credit rating of BB+ or lower, and registered an annual measure below one in at least one year out of the next five. The forecast year of capital market dependency represents the first year that a firm's cash resources and cash-generating power are not expected to keep pace with its debt-like obligations coming due in that year. Ratios of less than one can be considered benign for highly-rated firms, as those firms may simply refinance an impending debt maturity. However, we believe the annual measure is an informative liquidity assessment for poorly-rated companies that may not have access to easy credit. The annual measure is also a useful tool for identifying firms that may depend heavily on healthy functioning credit markets going forward, something we were reminded of very recently, and that we cannot take for granted.

Brian Nelson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.