Seven Global Car Maker’s KPI’s Part 4: Liquidity and Debt
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Financial management in a global carmaker is more complex than most. Carmakers commonly manage both global industrial businesses and global finance companies at the same time. They make vehicles and most finance vehicle purchase and leasing as well. As a result, managing large flows of cash and debt, and the risks associated with them, is their daily activity. How do we know if they are sound?
The financial resilience of a business stems from a combination of the risks linked to three core financial concepts – liquidity, solvency and debt. Liquidity and solvency are often coupled but mean two different things. Liquidity is a firm’s ability to pay its debt obligations when they fall due. Debt obligations can be in any amount, but the key factors in liquidity remain the same: cash and timing. Solvency is a broader concept that measures if the value of the firm’s assets is equal to or greater than its liabilities. It makes two balance sheet measurements: One, are total assets greater than total liabilities? Two, are current assets greater than current liabilities? Debt, for businesses, takes many forms, from ‘plain vanilla’ term loans and mortgages through to bonds and complex structured financial instruments, but they too have common features: a repayment schedule; a cost; a consequence and a risk.
To start with analysts assess these core financial concepts using ratios. Two common ones are Current Ratio and Financial Leverage. If either of these gives unusual results, they lead to more ratios used to uncover further facts. So, how well did our 7 car makers do against these two ratios?
Current Ratio (Current Assets/Current Liabilities):
In 2016 BMW’s Current Ratio returned to its long term average for the last decade of 0.98:1. It rose in 2009, when inventories grew during the financial crisis, and then followed a steady downward path. The ratio is less than 1 because BMW’s current assets are less than its current liabilities, so it fails one of the solvency tests. It uses its current liabilities – the creditor’s money – to more than finance its current assets. This has two benefits for BMW: it reduces their finance costs – they do not pay for the money – and it boosts their cash flow – they do not have to use their own funds to finance stocks or debtors, etc. What’s the risk of default? Not much for creditors in the short term, as BMW keep a cash ‘float’ of $6BN – $8BN, according to their balance sheet. However, it’s a risky policy – shared by other carmakers as described below – and there’s another concern. BMW’s current assets are growing faster than revenue. In 2012 $1 of current assets funded $1.52 of sales. By 2016 that had fallen to $1.41 of sales. That means they’re operating less efficiently too.
Daimler has kept its Current Ratio higher than its rival – above 1.15:1 since 2011, which is a less risky policy for working capital funding. They pass one of the solvency test. However, their management of working capital overall has been mixed: stock levels fell almost 4% overall between 2007 and 201 but, since 2014 stocks have been rising which is unwelcome. More positively, debtors (trade receivables) grew slower than sales since 2015 but, unhelpfully, net cash held in the business quadrupled between 2008 (€2.175BN) to 2016 (€10.246BN). This is probably linked to the requirements of their financial services company.
In 2008 Ford posted a loss of $14.6BN, its fourth loss in a row. Its share price fell to $1.8. In 2016 it posted a profit of $4.6BN and its share price sat at $12.31. How did this transformation come about? Ford’s Current Ratio fell from 2.76:1 in 2007 down to 1.2:1 in 2016. They pass one of the solvency tests but their headroom is diminishing. The primary change is that they reduced the amount of cash on hand from $33.6BN to $15.9BN. Much of the cash was used to pay off debt in the 2009 to 2011 period but that still left Ford with adequate cash to meet both liquidity and solvency criteria. More importantly, since 2012 their cash reserves have been growing again.
After a few years of exceeding the minimum benchmark. the Current Ratio in General Motors (GM) has slipped below the 1:1 standard yet again. Between 2007 and 2016 two large changes in GM’s working capital took place: current assets, in particular marketable securities, rose from $2BN to $16BN and current liabilities, mostly short-term borrowings, jumped from $6BN to $29BN. It’s the uneven expansion of liabilities greater than assets that is the prime area of concern for analysts. Their assumption is that the driver is GM’s financial division and that it may be connected to the increase in sub-prime auto lending to reduce stocks as the US market slowed in 2015 and 2016. It draws attention away from the gains GM has made in the General Motors International Operations (GMIO). It has retreated from loss-making markets, such as India and South Africa and shed its loss-making European brands. But, to be blunt, its current ratio still fails the solvency test.
Toyota, like Daimler and Ford, passes the solvency test. Their Current Ratio was greater than 1:1 throughout the 2007 – 2016 period and strengthened marginally each year. This placed a demand on cash flow of an additional $10BN in working capital and caused a reducion in working capital efficiency. The additional cash was used to fund bank deposits and marketable securities, presumably for the expansion of Toyota Finance. Between 2007 and 2016 the Operating Profit of the Automotive business hardly changed – around 9.4% while the Operating Profit of the Finance business rose from12.2% to 17.9%. The revenue of the automotive business grew 13.5% over the period while the finance business revenue grew 46%.
In the case of VW, the Current Ratio experienced a significant decline falling from 1.22:1 down to 0.88:1 for the VW group over the period from 2007 – 2016. This reflected two different policies: in the Automotive Group the Current Ratio fell from 1.37:1 in 2007 down to 1:1 in 2016, a decline but the division still met its solvency test; in the Financial Services Group the current ratio declined from 0.89:1 in 2007 to 0.79:1 in 2016 and clearly failed the solvency test. Its likely that, as the Financial Services Group is more profitable than Automotive, it has been allowed to expand as far as possible. It trebled business since 2007, while the Automotive Group less than doubled over the same period. However, alongside this expansion has been an increase in provisions for doubtful debts which are shown in the current assets. Of course, the reduction in the current ratio does bring cash flow benefits as outlined above with BMW, who operate a similar policy. Fiat-Chrysler (FCA) too have followed a similar path to as VW with their Current Ratio moving from positive (1.3:1) in 2007 down to negative (0.8:1) in 2007. Their fall in solvency has been the steepest of all the carmakers surveyed.
Financial Leverage (Total Assets/Equity):
An encouraging sign, is the trend in BMW‘s Financial Leverage. This compares total assets to equities and is slowly reducing. A reduction in the ratio suggests that shareholders equity is a growing proportion of the capital, which means that the firm can finance a greater proportion of its own growth and expansion. It also indicates that the exposure to increased interest rates or a downturn in sales is falling, so the business is less risky. The caveat when interpreting this ratio is that the asset side of the balance sheet should also be expanding, under normal circumstances. In the period since 2011 BMW’s total assets have grown by almost €57BN and, within that, its long term assets such as plant and technology by €40BN. The cash for these assets came from three sources: €20BN came from increased Debt, €17BN from retained profits and $3BN from internal cash. This had the effect of increasing the proportion of equity in the business as a whole. That development, plus the low interest rate environment of recent years, helped BMW further. Interest Cover (Profit Before Interest/Interest), already one of BMW’s strong points, improved even more. Since 2011 it has ranged between 22 and 38. In other words, BMW could make their interest payments between 22 and 38 times over, before making a loss. Sounds good, but during the financial crisis it fell to 3 times in 2008 and down to just over 2 times in 2009, which reminds analysts that carmakers have high fixed costs and a volatile marketplace.
Between 2007 and 2016 Daimler‘s total assets rose by €29BN, of which almost €18BN was invested in plant and technology and the rest, almost €11BN, mostly in inventory and net re-payments to short term creditors. These investments were financed by €15BN in retained profits and increased Long Term Debt of €14BN. Daimler’s debts rose slightly faster than their equity, which marginally impaired Daimler’s Financial Leverage. However, at 4:1, this too remains within prudent limits. Daimler’s Interest Cover reflected this, growing from just under 3 in 2011 to over 13 times in 2016.
Their task may not be complete but Ford provided a ‘master-class’ in financial engineering between 2007 and 2016. Ford’s Financial Leverage has been reduced from just below 12 times in 2011 down to 8.4 times in 2016. In 2007 it was just under 50:1. They achieved this by reducing and re-structuring their assets, to release around $42BN in cash between 2007 and 2016. They halted dividend payments for 5 years so that retained profit could be employed to provide another $24BN and they restructured their finance operation debts to release another $7BN. They used the funds to pay down and re-structure $75BN in long term debt. Interest Cover is still volatile but in 2011 it was 2.96:1 and in 2016 a much improved 8.6:1.
GM’s Financial Leverage is lower – between 6.5 :1 and 5:1, and improving, but this has been achieved at the cost of bankruptcy, access to low cost US Government ‘TARP’ funds and at the price of reducing its global distribution footprint by shedding brands and plants. Notwithstanding, it does now have a sustainable financial leverage and, since 2011, GM’s Interest Cover has trebled from 6 to 18 times.
The Financial Leverage at Volkswagen has been between 4 and 5 times for a decade, although since 2012 it has been rising, indicating a weakening of of the consolidated VW Group balance sheet. However, the financing policies for the Automotive and Financial Services divisions have been different and the highest risk is in the Financial Services business. The Automotive Business invested €42BN in current assets between 2007 and 2016, over half into extra stock, and a further €101BN mostly into new plant and technology projects. This was paid for by exra short-term borrowing and expanding creditors, which raised €57BN, €41BN in loans from their pension fund and banks and €44BN in Equity. As a consequence the Current Ratio of the Automotive business deteriorated from 1.67:1 down to 1:1, just about solvent but the Financial Leverage remained stable at around 3:1. In contrast, the Financial Services Business invested €45BN in current assets, between 2007 and 2016, and €75BN in long-term assets – mainly leasing contracts and other financial assets. These were funded by €64BN in payments on PCP and lease deals, €40BN in loans and €16.5BN in Equity. The Current Ratio dipped further below the benchmark – down to 0.77:1 – but the Financial Leverage improved – from 9.6:1 down to 8:1. With the strength of the VW Group, neither of these ratios are cause for alarm but they are evidence of higher risk in financial services.
Toyota is the most prudently managed of all the car makers surveyed when viewed as a consolidated group. In the the period from 2007 to 2016 their Financial Leverage did not reach 3 times in any year, although their total assets rose by €68BN. But, as with all carmakers that operate both an automotive and a financial business, the consolidated results obscure different risk scenarios in each division. In its Automotive business, which makes a net profit before tax (NPBT) of almost 10%, the current ratio improved from 1.19:1 in 2007 to 1.46:1 in 2016. Its Financial Leverage improved from 1.76 down to 1.67 in the same period. Its equity investment in the automotive division rose from 57% to 59%. On all tests the business is liquid, solvent and low risk compared with its industry peers. While the Financial Services division is also sound, there is a significant difference in risk. In contrast to automotive, the financial services division, whose NPBT rose from 11.6% in 2007 to 18.3% in 2016, has a current ratio of 0.80:1 – 0.85:1. Clearly it fails the solvency test. Its financial leverage across the entire 2005 – 2016 period was never less than 10:1 and the equity investment was never above 10%.
FIAT-Chrysler Auto shows the highest level of volatility in Financial Leverage. It was the second highest in the group, in 2016 5.4:1 – less than Ford (8.16:1). It has reported leverage as high as 10:1, but these extreme levels have been rapidly reduced suggesting that a firm level of financial management is now in control. The data set under the current management may be too short yet to predict its long term direction.
Keep in Mind
Managing the finances in a large corporation requires the vision to grasp the big picture of where funds are flowing from and flowing to and the ability to install and implement operational policies to ensure solvency and liquidity at all times. Many corporations, with skilled financial managers, have failed, often for simple reasons: they misunderstand the difference between cash and profit or lack the ability to read and respond to the financial information put in front of them. This post has tried to illustrate that all business is risky and that liquidity and debt KPI’s can highlight the presence of risk before it becomes too great to manage.
Ratings agencies assess risk and give companies ratings – much like credit scores – that identify the level of risk facing a business. Solvency, liquidity and debt are a central element of their evaluation. With that in mind and based on the analysis, what ranking should be awarded for each car maker in terms of liquidity and debt? Rank 1 is the top and rank 7 is at the bottom. Here’s my selection.
Toyota #1. Toyota take first place because they have the lowest Financial Leverage but have still expanded their assets considerably. They pass the Current Ratio solvency test. All of the risk they do have in their short term assets and liabilities are in its Financial Services division. However, the excess current assets in automotive exceed the excess current liabilities in financial services. An unexpected cash requirement should be fundable from the groups internal resources.
Daimler: # 2. Daimler ended 2016 with the highest Current Ratio and was more or less stable throughout the 2007 to 2016 period. As with Toyota, its consolidated Financial Leverage reflects its Financial Services division, not the business as a whole. Similarly to Toyota in 2016, the excess current liabilities in Financial Services (€16BN) can be repaid twice over by the excess Current Assets in Automotive (€33BN).
BMW: #3. BMW had the least weak Current Ratio in 2016 (0.98:1) as a group but, at 4:1, BMW has a lower Financial Leverage than Daimler, which pushed it into third place. But, in the event of an unexpected cash requirement they have significant unused long-term borrowing capacity so could withstand a significant cash requirement.
Ford: #4. Ford moves into number 4 slot because its positive current ratio (1.2:1) is the second lowest in the survey and it holds very minimal stock so, in the event of a cash demand, it could meet it without distressing its product. Admittedly, its financial leverage is the worst in the survey but it does have significant cash reserves.
Volkswagen #5. VW too has a weak Current Ratio (0.8:1) and its on a downward path. It’s also carrying high vehicle stocks, so will have to distress product in the case of an unexpected cash requirement. But worryingly, in 2016, the excess current liabilities in the Financial Services division (€19BN) were significantly greater than the excess current assets in the automotive division (€1BN).
GM: #6. GM is ranked at 6th place for two reasons: First, its current ratio has been falling since 2014 coupled with the fact that it carries high stocks, so it too will have to distress product in the event of a cash emergency. Second, it has a weak Financial Leverage compared to its peers.
FCA: #7. FCA takes seventh place because it has the weakest Current Ratio and has been on an unbroken downward pathfor its solvency since it was established. It does not have an in-house financial services division, so its weakness lies in its automotive activities. It has very high vehicle stocks and will have to distress the product in the event of an unexpected cash requirement. Finally, it has high leverage 5.4:1 and the improvements reported in its cash reserves since 2012 are mainly due to extra borrowing not income generated in the business.