Identify the companies most vulnerable to price shocks following the pandemic

Prepared by Julian Metzler, Benjamin Mosk, Nander de Vette and Peter Welz

Published as part of the Financial Stability Review, May 2022.

By the end of 2021, the aggregate profitability and indebtedness of non-financial corporations (NFCs) in the euro area had returned to pre-pandemic levels. While overall gross debt to gross value added remains elevated at around 160%, net debt has returned to pre-pandemic levels of around 100% of gross value added as companies have reserves of increased precautionary cash under favorable financing conditions. However, these aggregate developments were mainly driven by large companies, while the net debt position of small companies increased as they used credit to offset cash losses that were not covered by the support measures. public authorities. In addition, many businesses are now facing widespread increases in input prices due to rising energy prices and supply chain disruptions. Against this background, this box uses firm-level balance sheet data for around 91,000 euro area non-financial corporations to identify vulnerable firms based on Altman’s Z-score, a measure of corporate risk. insolvency that uses five balance sheet and income statement ratios and their common importance.[1], [2], [3] It then matches bank and sovereign exposures to account for related risks associated with the sovereign-bank-corporate nexus.

Although business revenues have deteriorated sharply during the COVID-19 pandemic, policy support measures have helped keep bankruptcies remarkably subdued. The economic effects of the pandemic have weakened corporate balance sheets, particularly in the services sector. At the same time, companies in the technology sectors and many consumer goods sectors have also benefited (Table A, panel a). Falling income seems to have been the main factor in the deterioration of financial health. Firm-level data also suggests that firms with higher levels of leverage experienced a greater deterioration in their financial health (Table A, panel b), and companies classified as weak had relatively higher debt, lower profits, and lower revenues than companies classified as healthy. Compared to the general decline in revenue, profits and margins remained relatively resilient. This is partly due to government support measures.[4]

Rising liabilities, lower cash levels and modest earnings continue to pose a risk for a subset of businesses. Translating Altman Z scores into implied corporate credit ratings, the share of companies that would be rated CCC or lower increased from 7.5% in 2019 to over 9% in 2020, consistent with the relatively benign downgrades among rated companies. Overall, however, the share of vulnerable companies (those with an Altman Z score below 1.81 or an implied credit rating below BBB-) has increased from 36% before the pandemic to 42% at the end of 2020. Overall, more companies migrated to a lower implied rating than to a higher implied rating.[5] Additionally, incoming quarterly financial results suggest that a significant share of businesses had not fully recovered by mid-2021. This reflects weakness in the tourism, entertainment and aviation sectors, while large listed companies in the technology and industrial sectors benefited from strong demand and improved their cash position.

Table A

The financial health of small businesses, highly indebted businesses and companies in the service sector has been hit harder by the pandemic, due to lower incomes

Sources: S&P Global Market Intelligence, ECB and ECB calculations.
Notes: Panel a: Gray line reflects lowest business threshold (1.81) based on Altman Z-score at end-2020. Altman Z-score is calculated as: 0.717 x working capital/ total assets + 0.847 x retained earnings/total assets + 3.107 x EBIT/total assets + 0.420 x equity/debt + 0.998 sales/total assets. A higher Altman Z score is associated with a lower default risk. Sample size (N) = 91,649. The sample contains about half of the total stock of NFC debt in the euro area and about 40% of total assets. The leverage ratio (total debt/total assets) of the companies in the sample is 34% compared to 30% for all NFCs in the euro zone. Panel b: sum of median changes of variables included in Altman’s Z-score: working capital (working capital/total assets), retained earnings (retained earnings/total assets), earnings (EBIT/total assets), revenue (sales/total assets) and equity (equity/debt). The upper graph reflects the impact on the 25th percentile of companies most affected by the pandemic in terms of Altman Z score. The lower panel reflects the evolution of Altman’s Z score by debt bracket measured by total debt / the company’s total assets. The level of debt is fixed on the level of debt and assets at the end of 2019.

Vulnerable companies are clustered in countries with high levels of sovereign debt, higher non-performing loan ratios and closer ties between banks and national sovereigns. Eurozone countries with higher levels of sovereign debt also have higher shares of weaker companies (Table B, panel a). For these countries, median Altman Z-scores also remain significantly below pre-pandemic levels. In addition, contagion vulnerabilities exist in several countries due to a closer nexus between the state, businesses and banks. These countries tend to have higher shares of vulnerable firms, and banks hold larger credit exposures to the national sovereign state; at the same time, the sovereign provided significant loan guarantees, in particular for loans to companies in vulnerable sectors (Table Bpanel b).

Table B

Corporate vulnerabilities are concentrated in countries with high sovereign debt and weaker banks

Sources: OECD Trade in Value Added (TiVA) database (2018), S&P Global Market Intelligence and ECB calculations.
Notes: Part a: A higher Altman Z score is associated with a lower default risk. The graph excludes Estonia, Cyprus, Latvia, Lithuania, Luxembourg, Malta, Slovakia and Slovenia due to the small number of companies in the sample. The size of the bubble reflects the raw NPL ratio. Sample size (N) = 91,649. Panel b: PGS stands for public guarantee scheme. Yellow circles represent low Altman Z-score countries, i.e. those with a Z-score

Weaker firms and firms with lower pricing power are more vulnerable to supply chain disruptions and rising input prices. Indices measuring input prices for euro area producers rose sharply in 2021 and the first months of 2022, driven by rising energy costs and bottlenecks in the economy. ‘offer. Additionally, some key inputs posted double-digit price increases. The sharp increase in prices and input costs will likely put pressure on profit margins, especially for companies that have weaker pricing power and cannot easily pass on price increases. This could create short-term cash flow problems and compromise medium-term debt sustainability and investment capacity. Vulnerabilities are concentrated in firms at the intersection of lower pricing power and those with higher production energy intensity and lower Altman Z-scores (Table Bpanel c).

Overall, business vulnerabilities remain and correlate to pandemic exposures and fallout from the Russian war in Ukraine. Overall, the corporate sector has weathered the shock of the pandemic, as evidenced by the recovery in profits. However, the Eurozone has a large cohort of vulnerable small businesses that are still recovering from the pandemic and are now facing additional cost pressures due to the sharp rise in input prices seen in recent months. At the current stage, financing conditions remain in their favour, but they could deteriorate rapidly if the economy slows down and lenders reassess the risks associated with certain business models. Moreover, uncertainty will reduce investment and contribute to clouding growth prospects in the future.

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