Credit Guide 03/22: Rizici i pokazatelji u analizi high-growth kompanija (in English)

Digitalisation enables a quick scale up, so today even a small company from Croatia can expand its business globally. Some industries are more suitable for quick and high growth, and they are mostly related to some type of intangible product. Hence, we most often see IT and generally tech companies topping the high-growth lists.

However, high growth brings many risks which can ruin the company even before it got a chance to reach a certain level of sales or profits. And it’s not only debt and equity investors who will lose their money, but potentially also the company’s suppliers and employees.

In this article we try to answer the most common questions related to the credit assessment of high-growth companies.

What is a high-growth company?

Rating agency Standard & Poor’s considers a high-growth company one that exhibits real revenue growth in excess of 8% per year. Real revenue growth excludes price or foreign exchange related growth. So, there is no minimum revenue threshold for a company to be considered a high-growth company, and it can be a start-up, a mid-size company, or even a large incumbent in a traditional industry. Sources of growth are either organic growth or acquisitions.

What are the biggest risks associated with high-growth companies?

The biggest risk associated with high-growth companies is overtrading.

Overtrading is a situation where a company rapidly increases sales volume with a goal of increasing profit or gaining market share, but at the same time creates a liquidity issue as a result. Significantly higher sales require  additional working capital, which, if not available, can create liquidity issues and lead the company into a bankruptcy. Even if the industry a company operates in is generally not working-capital-intensive (like retail for example), high growth requires additional resources like capital investments or new staff, thereby increasing the fixed costs / operating leverage.

To support high growth, companies often need additional liquidity, which normally comes from two sources – debt and/or equity. Debt repayment is a fixed cash outflow, so the company has to generate enough cash flow to cover it. Missed debt instalment often equals default, and it might be the end of the company’s existence. Bringing new equity investors has its costs too. New investors often cause a shift of powers in a company, they introduce new rules and limitations, all of which can lead to changes in corporate culture. In the end, the focus on investors’ interests can severely impede the original business idea and the company’s raison d’etre. There are also quasi debt/equity solutions, with elements of both debt and equity, so the risks are similar as previously mentioned.

How is high growth reflected in a company’s financial statements?

High growth can impact a company’s financial statements in many ways, but here are the most common signs:

• Significant revenue growth
• Improving operating margins on a year-on-year basis due to larger scale (note that profitability can also be hampered if the growth is too high due to increasing operating inefficiencies)
• Weak or negative NOCF and FCF
• Increase in net working capital in absolute amounts and/or in operating cycle duration
• Weakening liquidity ratios
• Increase in borrowings (or quasi debt/equity, or equity only).

The impact will depend on the growth rates, business model, company size, industry the company operates in, etc.

How does high growth affect a company’s credit rating?

Impact of high growth on a company’s credit rating will depend on the industry the company operates in, its business model, future growth opportunities, and existing leverage level and capital structure.

Normally, high growth requires additional funding, which often leads to an increase in debt or debt-like obligations. That said, it is unlikely that the high growth will improve credit rating in the short-term, as growth sustainability and health has to be proven yet. In addition, it is important to consider whether the sales growth is of a temporary or permanent nature, i.e., is the company targeting high growth in one or two years or for the foreseeable future. Negative credit rating impact of higher leverage can be alleviated by an increase in company’s size and improved competitive position, however, it normally takes time for this to show results. Should the high growth be financed solely with equity, then the credit rating might not be impacted negatively, provided the company has not entered a completely unknown and high-risk market.

Many companies pursue acquisition growth strategies, which have become more relevant over the past years due to an abundance of liquidity in the market. However, large acquisitions normally require new, external funding. It often comes in a form of new debt, more specifically in a form of bridge / acquisition financing before a long-term financing structure has been put in place. Although the acquisition often increases leverage, at least in the short-term, in many cases of large global companies we have not seen a rating change. This reasoning comes from an estimate of potential synergies, be it on the competitive position front, or a potential to cut operating expenses. However, acquisitions often fail due to a failed integration of the target and a failure to achieve synergies initially expected. It is worth remembering the approach of the investing guru Aswath Damodaran, who normally sells all shares of the company which enters into a large acquisition, as acquiring companies tend to overpay for their targets.

What are the key debt service metrics for high-growth companies?

When assessing the debt service capacity of high-growth companies, typically the focus is on the Debt / FFO metric. This is because the ratios focusing on NOCF or FCF can vary significantly depending on the growth investment the company is undergoing. FFO excludes the volatile movements in working capital and CAPEX stemming from the investments. If the company’s investment is largely reflected through CAPEX and not working capital, then the Debt / NOCF metric can also be useful to assess the company’s ability to generate cash flow after working capital.

Special care has to be exercised in case of large acquisitions, where we recommend the usage of the debt service metrics on the company’s pro forma figures accounting for the acquisition.

In any case, we always recommend placing more emphasis on projected ratios then historic ones.

If you wish to know more, please send a message to mario@creditanalyst.eu, the contact form on https://creditanalyst.eu/en/contact/, or call us on +385 98 920 17 13.