Second Quarter 2020 Amid COVID-19: Investor and Audit Committee Considerations: Cash Is Not Just King, It Is Everything

As we noted in our introductory post on July 14, as the earnings season commences this week, we will undertake a series of posts over the next two weeks on issues we believe are important for investors and audit committees to consider. In this post, we cover the first of these considerations: cash and liquidity.

We are starting this series with cash and liquidity because the cash position affects the ability of a business to continue to grow and thrive, and the state of the business drives its ability to generate cash. As we learned from the Great Recession of 2008/2009, cash is king. This pandemic, however, and the resulting dramatic contraction of demand and shutdown of the globally economy — the likes of which are more rapid and substantial than the 2008/2009 financial crisis — demonstrate that cash isn’t just king, it is everything. The extreme stress test for a company is its ability to weather the time between the onset of the pandemic and the creation of a reliable vaccine in, at best, 12–18 months.

Following are our top 10 questions for cash, which we elaborate on next:

1. What is the company’s cash burn rate?
2. How does cash on hand compare to the expected cash flow needs in the coming quarter?
3. Can cash be moved freely around the company or are there tax, legal, or other restrictions on it?
4. Were lines of credit tapped and are additional draws or facilities needed?
5. Were debt covenants pierced?
6. Will stock buybacks and dividends be reduced or curtailed?
7. What are the company’s contractual obligations for the upcoming 12 months?
8. Are there any off-balance sheet arrangements that will require cash funding commitments, or the consolidation of assets and liabilities previously only disclosed?
9. Are there any changes to capital allocation plans or impacts to strategic liquidity plans?
10. Have the parent company–only financial statements been provided, as the investor owns an interest only in the parent company?

Investors need to consider the following:

1. Cash Position and Cash Burn — As companies talked about their historical results for first quarter, they also focused on their cash position and their financial flexibility. Without seeing results of the impact of the pandemic — which most significantly affected the second quarter — it was challenging for investors to assess whether the cash position at 31 March was sufficient to weather the shutdown. In fact, we have seen numerous companies declare bankruptcy in the second quarter. As such, the second quarter will require a possibly more important look at the cash position on the balance sheet after, hopefully, the worst of the pandemic has occurred. Investors should ask the following questions: How much of the 31 March cash position was gobbled up in the second quarter? And will companies provide a statement of cash flows as part of the “earnings release” or will that information be provided with the rest of the full financial statements when it is issued? The statement of cash flows should show the “burn rate” for cash highlighting the variable versus fixed costs, management’s actions to reduce the outflow of cash, and the cash-generating ability of the business. Investors — as well as auditors and audit committees — need to assess how many more months of cash the company has and what other actions might be necessary to reduce cash outflows.
2. Operating Cash Flows: Historical and Projected — Investors should compare the cash on hand with the expected cash flow needs in the coming quarter and the coming year, asking several questions: What are the traditional operating cash flow needs? What proved to be fixed versus variable costs and cash flows in the second quarter? What are the expected cash flows for the next 3–6 months based on the traditional cash flow needs of the business and those witnessed in the second quarter?
3. Location of Cash and Restrictions on Cash Flows Between Entities — As a part of this, investors also need to be mindful of the location of cash, asking questions such as the following: Where is the cash? What legal entity and what country? What, if any, restrictions are there on the flows of cash between legal entities and countries? Are there tax penalties for repatriation of the cash? Is the cash located in the legal entities with the most immediate liabilities? As we will note in the discussion of parent company cash flows, the consolidated financial statements can be unhelpful to investors when it comes to a liquidity crunch if they presume the free flow of cash between subsidiaries and jurisdictions, which may not be the reality of the business.
4. Borrowings and Lines of Credit — During first-quarter earnings calls, many companies talked about their available lines of credit and the additional borrowings they made in late March and April. In the second quarter, investors will need to assess whether and to what degree lines of credit were tapped and whether additional draws were necessary — or whether additional facilities were necessary. Many government programs were implemented to facilitate the functioning of debt markets that resulted in these additional borrowings during March and April 2020. Investors will need to take a step back and ask: Was this enough both on a micro-company level and a macroeconomic level? What are the risks to the company from availing itself of these government programs? From the quarter or half-yearly reporting of results, policy makers also should pay attention and assess whether, or not, additional actions may be necessary.  
5. Debt Covenant Issues — While not discussed significantly during first-quarter reporting because the economic effects of the pandemic were just beginning to be felt, investors should be mindful of a company’s debt covenants and whether they have been pierced or adjusted through negotiations with lenders. This happened during the 2008/2009 financial crisis but was not prominently disclosed for many companies.
6. Stock Buybacks and Dividends — Many companies announced the suspension of stock buybacks during the spring as the pandemic worsened. Some suspended dividends while others reaffirmed their commitments to maintaining their dividends amid the pandemic and bolstering their financial flexibility to do so. In some jurisdictions, regulators required the suspension of not only stock buybacks but also dividends — whereas in other jurisdictions, such as the United States, caps were placed on dividends in financial institutions based on trailing earnings. Investors need to assess the reality of a company’s dividend paying ability over the next 12–18 months.
7. Contractual Obligations Table — In the United States, companies are required to complete a contractual obligations table in their annual Form 10-K. During times of economic uncertainty or financial instability, this table is more important than ever. Investors need to review this disclosure in the forepart of Form 10-Q and compare it with year-end and first-quarter reports. If the company’s results show a dramatic change, investors should request this table if it is not included in the Form 10-Q, because it provides a fantastic forward-looking summary of the companies upcoming cash obligations and commitments. In jurisdictions in which this is not a requirement, we suggest investors comb through financials to construct a similar table or ask management to provide it as it is essential to assessing financial flexibility. Interestingly, the SEC is considering removal of this table as part of a proposal to revise sections of management, discussion, and analysis. Comment letters on this proposed rule were due as the pandemic worsened. CFA Institute highlighted the importance of this table amidst the liquidity issues brought about by the pandemic in its comment letter to the SEC and in the article “COVID-19 Highlights Need to Reset SEC Proposal on MD&A Disclosures.”
8. Off-Balance Sheet Arrangements — Investors should be mindful as to whether any off-balance sheet arrangements have been triggered that require cash funding commitments or the consolidation of assets and liabilities previously only disclosed. This was the downfall of several financial institutions during the 2008/2009 financial crisis. Repurchase transactions and illiquidity of underlying securities may result in additional cash flow requirements. Investors should keep their eyes peeled for such events — likely disclosed in commitment footnotes that people generally do not read too closely.
9. Liquidity and Capital Resources — Investors should expect an expanded liquidity and capital resources section in the US Form 10-Q — and the respective public company reports globally. If such a liquidity analysis and discussion is not provided, investors should ask for it. Investors need to know whether capital allocation plans and priorities have changed and understand the impacts of management’s actions on the overall strategic liquidity plans.
10. Parent Company Only Financial Statements — Interestingly, and surprisingly, many companies and investors forget the importance of parent company only financials at times of economic stress. Generally, companies do not provide parent company only financial statements — specifically parent company only cash flows — in their quarterly reports. SEC rules do require that if there is material change in the parent company’s cash flows, the parent company financials and statement of cash flows should be provided on an interim basis. Given that these are provided only annually, except in unusual circumstances, many financial reporting professionals forget about this requirement as it is not part of the routine preparation process. During times such as these, this information is especially important for investors, as the investor owns only an interest in the parent company, and not in all the assets in the consolidated financial statements. As such, investors should seek to understand not only the cash position of the consolidated entity but also that of the parent company. As we have noted, the inability to move money to the parent is an important issue to understand, especially in a regulated entity.

Much of this makes reference to US public companies because we have seen reporting from these companies for the first quarter. The issues are equally relevant for companies globally — although this information may be presented in different locations. What isn’t the same for global companies is that investors will not have the benefit of having the cash position at the onset of the pandemic in March and the isolation of the impacts of the second quarter, which may provide more meaningful insight on the pandemic’s most dramatic impacts. With six very different months aggregated, investors may have less ability to understand the impacts of the recession on the business.

Image Credit @ 2020 CFA Institute