IN DEFENSE OF SLACK
Conditions are tough enough when credit is scarce, either because of general conditions in the financial markets or as a result of deterioration in a company’s debt quality measures.
Sometimes the situation is much worse, as a company finds itself actually prohibited from borrowing. Bank credit agreements typically impose restrictive covenants, which may include limitations on total indebtedness (see “Projecting Financial Flexibility” in Chapter 12). Beyond a certain point, a firm bound by such covenants cannot continue borrowing to meet its obligations.A typical consequence of violating debt covenants or striving to head off bankruptcy is that management reduces discretionary expenditures to avoid losing control. Many items that a company can cut without disrupting operations in the short run are essential to its long-term health. Advertising and research are obvious targets for cutbacks. Their benefits are visible only in future periods, while their costs are apparent in the current period. Over many years, a company that habitually scrimps on such expenditures can impair its competitiveness, thereby transforming a short-term problem into a long-term one.
Avoiding this pattern of decline is the primary benefit of financial flexibility. If during good times a company can generate positive cash flow before financing, it will not have to chop capital expenditures and other outlays that represent investments in its future. Nor, in all likelihood, will a company that maintains some slack be forced to eliminate its dividend under duress. The company will consequently avoid tarnishing its image in the capital markets and raising the cost of future financings.
Despite the blessings that financial flexibility confers, however, maintaining a funds cushion is not universally regarded as a wise corporate policy.
The opposing view is based on a definition of free cash flow as “cash flow in excess of that required to fund all of a firm’s projects that have positive net present values when discounted at the relevant cost of capital.”7 According to this argument, management should dividend all excess cash flow to shareholders. The only alternative is to invest it in low-return projects (or possibly even lower-return marketable securities), thereby preventing shareholders from earning fair returns on a portion of their capital. Left to their own devices, argue the proponents of this view, managers will trap cash in low-return investments because their compensation tends to be positively related to the growth of assets under their control. Therefore, management should be encouraged to remit all excess cash to shareholders. If encouragement fails to do the trick, the threat of hostile takeover should be employed, say those who minimize the value of financial flexibility.The argument against retaining excess cash flow certainly sounds logical. It is supported, moreover, by numerous studies8 indicating the tendency of companies to continue investing even after they have exhausted their good opportunities. Growing as it does out of economic theory, though, the argument must be applied judiciously in practice. Overinvestment has unquestionably led, in many industries, to prolonged periods of excess capacity, producing in turn chronically poor profitability. In retrospect, the firms involved would have served their shareholders better if they had increased their dividend payouts or repurchased stock, instead of constructing new plants. That judgment, however, benefits from hindsight. Managers may have overinvested because they believed forecasts of economic growth that ultimately proved too optimistic. Had demand grown at the expected rate, a firm that had declined to expand capacity might have been unable to maintain its market share.
In the long run, failing to keep up with the scale economies achieved by more expansion-minded competitors could have harmed shareholders more than a few years of excess capacity. The financial analyst’s job includes making judgments about a firm’s reinvestment policies—without the benefit of hindsight—and does not consist of passively accepting the prevailing wisdom that low returns in the near term prove that an industry has no future opportunities worth exploiting.A subtler point not easily captured by theorists is that financial flexibility can translate directly into operating flexibility. Keeping cash “trapped” in marketable securities can enable a firm to gain an edge over “lean-and- mean” competitors when tight credit conditions make it difficult to finance working capital needs. Another less obvious risk of eschewing financial flexibility is the danger of permanently losing experienced skilled workers through temporary layoffs occasioned by recessions. Productivity suffers during the subsequent recovery as a consequence of laid-off skilled employees finding permanent jobs elsewhere. It may therefore be economical to continue to run plants, thereby deliberately building up inventory, to keep valued workers on the payroll. This strategy is difficult to implement without some capability of adjusting to a sudden increase in working capital financing requirements.