No new way for a company to go bust but the signs of default existed long before its demise
Most experts when asked about why a company went broke or defaulted will respond with a collection of good logical reasons specific to the matter. In fact, insolvency practitioners are required to report this as part of their responsibilities as administrators. In our experience however there remains two key truths that hold for the reasons for the demise of a company:
- The signs pointing to default existed long before the event of default.
- There is no new way a company can invent to go bust or default
Businesses heavily exposed to a particular sector will have a vested interest in tracking, over time, the potential for corporate default with stakeholders important to their business. Understanding these trends can help organisations make informed decisions, and reduce their risk when dealing with counterparties in a sector experiencing declining or weak corporate health.
Lenders have traditionally looked to the rating agencies to get guidance on the quality of the credit worthiness of borrower. Ratings agencies view a credit through a lender’s eyes but lenders aren’t the only stakeholder impacted by the default of a borrower – suppliers, customers, employees and their families, and sometimes whole communities are impacted. Such stakeholders have difficulty in interpreting the ratings and not everyone has access to or interest in the rating, and therefore the average supplier, for example, has no indication of the borrowers’ financial health.
To provide a new perspective, we came at the problem of predicting default through the eyes of a restructuring professional who deals with all stakeholders (not just lenders) and we’ve delved deep into this issue in our new, biannual report, Distance to default – A default indicator for Australian listed companies, where we gauge if an industry has either moved closer to or further away from default.
Bringing together analysis from information available for the majority of Australia’s ASX listed companies and having modified the Distance-to-Default (D2D) measure used by the Reserve Bank of Australia, we think the D2D measure provides meaningful insights into the trends in corporate health across sectors and the ASX over time. That is, has a sector (and a company relative to its peers) moved closer to or further from default. It’s a simple measure designed to support stakeholders to understand their counterparty risk.
What emerged from the analysis is the comparative distances from default across sectors measured against the ASX. Sectors with an average D2D score closer to zero, and companies with a D2D score below 0.5 (when compared to other sectors, are considered to have weaker corporate health and may attract higher default risk among their constituents (sector companies). Of the 183 companies with a score above 3.0 (considered to be less at risk than those below) at June 2016, 27 percent were in the Real Estate sector, compared to 14 percent as at December 2013, indicating the Real Estate sector has moved further away from default. Conversely, of the 222 companies with a score below 0.5 as at June 2016, 52 percent were in the Metals and Mining industry, compared to 56 percent as at December 2013, indicating that industry constituents have experienced a sustained period of stress and default risk.
We don’t have the crystal ball that predicts the future – unfortunately. However perhaps a simple assessment of the likelihood of default measured over time will help stakeholders understand their counterparty risks when dealing with a corporate.