The Core of Sustainability During Unprecedented Times
Having hit by a once-in-a-century global pandemic, the importance of sustainability has been more severe than ever before, whether in relationships, businesses, various industries, or the entire economy. It is a test of the whole ecosystem where going back to the fundamentals and working with the key levers have proven significant. On one side, this environment creates difficulties for some to sustain while that very problem creates opportunities for others to grab. What is important to note is that everyone on the absorbing end needs to be in a sustainable position and take advantage of the opportunity that presents.
At the core of every business is protecting its shareholders' best interest, i.e., the enterprise value and return on shareholders' equity. One of the critical methods of calculating Enterprise Value (EV) is identifying the market value of equity and subtracting net debt. The levers one has got to play with are these two; you can either increase or at least try to keep consistent the equity value; or decrease or at least try to keep constant the net debt value.
The market value of equity is often calculated by multiplying a company's Earnings before Tax, Depreciation, and Amortisation (EBITDA) to its industry determined multiple adjusted for its health. In a scenario where revenue is suffering for most industries amid the global phenomenon, EBIDTA or profit is bound to be down unless a strong position in controlling costs has been taken to keep the profitability ratio the same. While cost of goods sold is understandably proportionate to revenue or production, fixed and overhead prices are not and often have a less immediate outcome when an action is taken to reduce it. When every player in an industry suffers from the same macro adversities, multiples on EBITDA are less likely to swing. This makes cost control to keep the business's profitability as consistent as possible the critical aspect in holding up the value of equity in a company.
The other lever a business has to work with is its net debt, formulated by subtracting free cash from actual debt. Often a dangerous attempt taken by companies to carry on in their survival mode is to take on debt to cover working capital. It's not necessarily wrong if handled carefully. Still, it can turn out to be a sunk cost if, after injection of such debt, the revenue and profitability do not change, in which case it is wrong because the debt has been used to spend instead of invest. But we are talking about net debt here, which has another component within – free cash. As we have always known, cash is king, and it is more important than ever to keep a stronger cash position during a macroeconomic crisis. Often it's not necessary to pay out the debt with free cash. A healthy cash balance can be maintained to offset the actual debt to make the deficit smaller, thus creating a lower net debt position.
The amount of free cash flow of a business provides for its runway to determine how long it can sustain its cash balance. Sustainability during unprecedented times lies in holding a solid cash position and robust management of cost control mechanisms which the business is somewhat in control of. The macro market situation does not have individual companies. With effective management of these levers, some businesses put themselves in a position to sustain or even buy out other assets or businesses in distress who have possibly not been very effective managers of those same fundamental aspects and find themselves in a vulnerable position.
Author: Asif Kawnine MAICD