In analysing the credit risk of an issuer, analysts seek to uncover the economic realities of the company in focus. To that end, among the many items reviewed by analysts are the company’s financial statements, enabling them to assess its ability to meet its financial obligations. Seems pretty straightforward – and, to state the obvious, in assessing credit risk, analysts will focus on the cash flow statement because, after all, a company can’t service debt with widgets or earnings. In addition, as one of many measures of financial risk, credit analysts look at a company’s net leverage, defined as gross debt less cash divided by EBITDA. As straight forward as all of this seems, these methods are limited in their effectiveness because of the disclosures available to analysts. For instance, without getting into a philosophical discussion about what is meant by “cash” and “debt”, there are a few simple things that a company can do to make its disclosures more useful.
Improving disclosures about debt and cash is the principal rationale behind the proposed improvements by the International Accounting Standards Board (IASB) to IAS 7: the accounting standard behind the cash flow statement. As an investor in global credit markets, we think the proposed changes make a lot of sense, can be implemented easily and are consistent with what is disclosed to shareholders.
The first component of the proposed amendment is to require companies to include a reconciliation of debt balances from the beginning of the accounting period until the end. This part of the amendment addresses a shortfall of the current cash flow statement, which results in the fairly common situation when “non-cash” changes to debt occur during an accounting period. (This may happen, for example, when a company enters into lease arrangements or in an M&A situation.) Given that shareholders have the benefit of a statement to the changes in shareholders’ equity, we believe it would be entirely consistent for companies to disclose similar information for the benefit of creditors related to changes in debt balances. While it is true that many companies provide this information voluntarily as part of their earnings presentations, a change to IAS 7 would create consistency across all users of International Financial Reporting Standards.
The second of the two changes to IAS 7 is to require information that will help identify how much of a company’s cash balance is restricted and therefore readily available to the company. This is important, if, for example, a sizeable portion of a company’s cash balances are “trapped” in a foreign jurisdiction due to punitive tax liabilities arising from repatriation of the cash, or restricted in some other way. For an analyst to capture this economic reality, they would have to deduct the restricted cash from the cash balance used in the net debt (and therefore net leverage) calculation. As it currently stands, these restricted cash balances are included in cash and cash equivalents. Consequently, we have no real idea how much of that cash could be used to service debt. Therefore, to distil the cash balance of a company operating on a global basis, an analyst needs to ask the company for details on any encumbered cash. And even if they do, details are not always provided. The requirement to provide these details, as per the proposed changes to IAS 7, can be easily adhered to and makes a lot of sense for the purpose of transparency and the calculation of credit metrics that more accurately reflect the economic realities of a company.
As a global investor, Hermes Credit is very much in favour of these proposed amendments and hopes that the IASB proceeds to a final amendment. As for next steps, the IASB is reviewing the comments letters received on the proposals ahead of discussions with the IASB, hopefully in June.
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