Young, fast-growing companies very often look for debt financing as soon as possible in their lifecycle. They are currently incentivised to do so – particularly to finance their environmental transition – with the decrease in interest rates since the beginning of the year.
When confronted with potential investors, the temptation to embellish their reality through overly optimistic forecasts is naturally quite high, paving the way for storytelling, to the detriment of a clear focus on sustainable cashflow generation. This is just an illustration of the difference in approach between equity analysts and credit analysts.
One cannot stress enough the risk associated with disconnecting ‘cash’ from the accounting reporting, especially under IFRS.
Credit analysts generally adopt a more conservative approach when it comes to forecasting. They look for stable cashflows, recurring revenues, and security, to cover the debt servicing costs with sufficient headroom. As a matter of fact, unprofitable businesses are penalised when it comes to credit analysis. Additionally, lower credit quality means higher interest costs, making debt financing less attractive for these companies and putting pressure on their cashflow.
Assessing the overall creditworthiness of companies is a mix of assessing their business risk profile and their financial risk profile, combined with some ESG assessment both at the industry level and with respect to the company’s own practices.
Young companies seeking financing often present the same characteristics: innovative/disruptive products with promising prospects in the targeted market, but low or negative EBITDA, and by extension negative free cashflow. Regardless of the degree of maturity of a company, the business risk profile and the financial risk profile are inseparable as financials always reflect how business is conducted.
Not being able to generate sufficient positive EBITDA generally entails weak cashflow metrics, albeit sometimes temporarily mitigated by recurring equity injections (to support growth and related funding needs). This enhances the capitalisation ratio (equity/debt) but can also positively impact the net leverage ratio (net financial debt/EBITDA).
Regarding their business risk profile, the competitive positioning of these companies also turns out to be mixed. The industry risk assessment is favourably impacted by that of the entire sector. On the flipside, company-specific factors, such as scale and diversification, are obviously rather weak in the absence of maturity. Consequently, being rated by reputable credit rating agencies with validated methodologies is paramount for them.
While corporate ratings for this type of companies are often naturally capped at the B category, thanks to additional securities, pledges, collateral assets granted to creditors etc, instrument ratings can sometimes be higher than the corporate rating. This does not automatically disqualify debt financing from a company’s options but makes it even more essential to receive a rating from a credit rating agency.
While credit analysts acknowledge that ramp-up phases are essential, cash-consuming steps in the life of any company, financial counterparties have reinforced their requirements on the back of a prudent approach.
In the end, young companies’ CEOs have to bear in mind that EBITDA must cover interest expenses, and that debt service must be covered by annual cashflows. Profitability and recurring cashflows are indeed the key to a good credit rating, and by extension to facilitate access to European debt markets to finance growth.
