Financing the business sector during the credit boom and the credit crisis

Contents

1 Introduction

2 Financial Crisis

3 Corporate Financial Management

4 Impact Financial Crisis on the Construction Industry
4.1 Overview
4.2 Small Businesses
4.3 Large and Medium-Sized Businesses
4.3.1 Analysis of Financial Key Performance Indicators and Ratios
4.3.2 Analysis of Financial Instruments
4.4 Cost of Capital
4.4.1 Cost of Debt
4.4.2 Cost of Equity
4.4.3 Weighted Average Cost of Capital

5 Conclusion

6 References

7 Appendix

List of Figures

Figure 1: US unemployment vs. US construction industry unemployment

Figure 2: Left - US interest rate 2004-2010 / Right - US Credit market volume 1986-2010

Figure 3: Economic crisis stimulus packages across different countries

Figure 4: Impact of the financial crisis on business funding options

Figure 5: Construction segmentation

Figure 6: Small business sales and the small business “outlook” 1974 - 2010

Figure 7: Primary financial institutions of small business

Figure 8: Value of small business loans outstanding in Billion US$

Figure 9: Credit access conditions for small businesses - 2006 vs. 2009

Figure 10: Credit access conditions for small businesses - 2009 vs. 2010

Figure 11: EBIT in Mio. US$ - averaged across all businesses analyzed

Figure 12: Revenues / Cash / Fixed Assets in Mio. US$ - averaged across all businesses analyzed

Figure 13: Liabilities in Mio. US$ - averaged across all businesses analyzed

Figure 14: Current Liabilities to Equity - averaged across all businesses analyzed

Figure 15: Accounts Receivable in Mio. US$ - averaged across all businesses analyzed

Figure 16: Accounts Payable to Revenue - averaged across all businesses analyzed

Figure 17: US credit market borrowing / All sectors by instrument (

Figure 18: Outstanding shares in Mio

Figure 19: Volume of outstanding bonds in Mio. US$

Figure 20: Volume of interest paid in Mio. US$ - averaged across all businesses analyzed

Figure 21: Cost of debt calculation example - (Calculation Basis, Standard Pacific, 2006)

Figure 22: Cost of equity capital - new issue

Figure 23: WACC in % - averaged across selected large businesses

List of Abbreviations

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1 Introduction

“In total, we've lost nearly 1.2 million jobs this year, and more than 10 million Americans are now unemployed. We are facing the greatest economic challenge of our lifetime.” (Fox News, 2008) - in 2008 US president Barack Obama summarized the impact of the financial crisis on the US economy.

The US construction industry, which accounts for approximately 8% of the overall GDP and employs 6.7 million workers, was adversely affected by the financial crisis (Research and Markets, 2010 - see figure 1). James Sudbury a consultant for the construction industries analyzed in August 2008: “The markets changed dramatically in the last three months. There used to be plenty of money all over the street. Now, it's difficult to get it done with any major banks” (Ireland & Writer 2008). In conjunction with other relevant factors the significant dependency on a high cash flow level, contradicting the money and capital market climate during the financial crisis, has strongly driven the negative economic trend of the industry.

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Figure 1: US unemployment vs. US construction industry unemployment (Hendricks & Golden, 2010)

In order to examine the impact of the financial crisis on the US construction industry by business segment this paper first summarizes external influences and outlines basic principles of corporate finance.¹

2 Financial Crisis

The US economy was heavily affected by the economic crisis generated by the collapse of the real estate bubble. Financial markets reacted on negative developments accordingly. Banks started to suffer remarkable losses derived from inadequate lending practices in the field of subprime mortgages during previous years (Sleight, 2008). In addition, the US stock market failed in facilitating capital formation, the IPO market was crippled, inadequate and inefficient. The market volatility as a measure of risk reached extremes. The decline in the number of businesses listed in the stock market has caused remarkable costs for the US economy due to the loss of millions of jobs. Furthermore it limited the access to debt capital and diminished the rate of financing derived from the sale of shares (Weild & Kim, 2009). Interest rates continued to increase until they dropped to a minimum by the end of 2008. As a consequence the credit market volume, which peaked in 2006, collapsed (see figure 2).

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Figure 2: Left - US interest rate 2004-2010 / Right - US Credit market volume 1986-2010 (Federal Reserve, 2011)

Stimulus packages created by the respective governments were expected to compensate negative developments. The US specifically assigned 64% of total funds (see figure 3) in the form of capital investments (Germany only 22%), which was specifically relevant for the construction industry and will be discussed later in this paper.

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Figure 3: Economic crisis stimulus packages across different countries (Roland Berger, 2010)

3 Corporate Financial Management

“Corporate financial management is defined as the management (investment) and acquisition (financing) of monetary resources over time to maximize the wealth of its owners or value of a company” (Kumar, 2011).² In order to obtain funding, enterprises are provided with a variety of options, each characterized by its own benefits and costs. Equity and debt financing can be classified as the two external resources, whereat internal financing is utilizing profits as a source of capital to promote new investments (Brealey et al, 2008 - see figure 4).³

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Figure 4: Impact of the financial crisis on business funding options (Own Figure)

Financing options differ between small, medium and large companies based on variables such as business size and years of operation. Smaller businesses primarily rely on bank credits and private equity markets as they lack, in contrast to large businesses, the required informational opacity and financial power to go public⁴ or participate in bond markets (Bragg, 2010). Differences in obtaining monetary resources across US construction businesses are outlined below in order to examine in a second step the impact of the financial crisis on the respective company segment.

4 Impact Financial Crisis on the Construction Industry

4.1 Overview

“Tighter credit standards may affect smaller construction businesses first. The small business contractor is not going to have access to as much external capital as a large contractor will” says a partner in Business Finance Solutions underlining the different levels the industry was impacted by the economic downturn (Ireland & Writer 2008). Hence, it is necessary to divide the analysis of the crisis’ aftermath into three parts, covering different sizes of companies. For the purpose of this project the number of employees is selected as the relevant classifier. In contrast to the precise guidelines promoted by the European Commission (European Commission, 2010) there are multiple approaches communicated by different US institutions (US Small Business Administration, 2010 & US Census Bureau’s, 2002). This paper aligns with the main direction promoted by the US Census Bureau’s, however, considering the specific characteristics of the construction industry, this definition is adapted slightly and applied for this paper as displayed in figure 5.

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Figure 5: Construction segmentation

4.2 Small Businesses

In 2010 US President Obama titled small businesses as “the backbone of our economy and the cornerstones of our communities” (Sabochik, 2010). In fact, small businesses represent one-half of the US private nonfarm employment and GDP (Medearis, 2010). This business segment was heavily affected by the financial crisis, yielding almost 60% of the net job losses in 2009 (SBA, 2010) as business conditions decreased rapidly (see figure 6).

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Figure 6: Small business sales and the small business “outlook” 1974 - 2010

As the construction industry is strongly driven by small businesses this sector was facing the heaviest impact caused by economic downturn (Medearis, 2010). Limited access of small companies to private equity and bond markets underlined the importance of bank loans in financing this business segment. In 2003 70.7% of small mining and construction businesses utilized any traditional loan, while 79.1% used any nontraditional loans (see table 1 and figure 7 - Medearis, 2010).

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Figure 7: Primary financial institutions of small business (Medearis, 2010)

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Table 1: Share of small mining & construction firms using credit - 2003 (SBA, 2009)

Small construction businesses were strongly affected by tight loan lending conditions applied by many banks as a reaction to the financial crisis since 2007. Comparatively detailed review strategies were established by lending institutions before a loan could be granted, leading to a decrease in funds provided. Total volume of small business loans peaked in 2008 with more than $711 billion and decreased by 8.3 percent to $652 billion in 2010 (see figure 8).

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Figure 8: Value of small business loans outstanding in Billion US$ (SBA, 2011)

Small businesses have struggled in meeting strict loan granting conditions (see figure 9) for the following internal reasons: First, numerous small businesses do not have transparent accounting practices and are additionally facing insufficient financial reserves. Second, in order to obtain financial resources small business owners historically rely on personal assets besides external debt financing. 18% used private property as collateral or guarantee for loans and even have provided a loan to their business directly (Medearis, 2010). Losses in personal wealth, caused by the financial crisis have limited small business owners in making this type of financial commitments (Moon, 2009). Third, decreasing real estate prices negatively influenced the ability of small businesses to obtain debt funds. 95% of small businesses are listing real estate in their portfolio which was used as home equity loan or collateral during the boom period (Medearis, 2010).

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Figure 9: Credit access conditions for small businesses - 2006 vs. 2009 (Dennis, 2010 & 2011)

Dependency on bank credits in combination with open accounts receivables has pushed small construction businesses into financial difficulties and even bankruptcies. Only 40% of small businesses could meet all their credit needs in 2009 (see figure 10). According to the 2007 Construction Industry Financial Survey mismanaged cash flow was in 50% of all cases the reason why construction businesses went bankrupt (Irland and Writer, 2008). As a consequence of dried out credit markets small businesses were forced to seek for alternative funding solutions. Leasing was a preferred option selected by many small construction businesses, which in general requires capital intensive equipment such as cranes. Productivity, profits and liquidly could be derived and secured without affecting the balance sheet and its corresponding KPI’s such as the debt to equity ratio.

The introduction of the US fiscal stimulus package, signed in February 2009 (see chapter 3), could partially compensate the omission of projects assigned to small construction companies by private and business clients. In conjunction with a higher level of capacity utilization, conditions for internal financing improved slightly (Medearis, 2010). However, poor sales and uncertainty continue to rank first and second in 2010 when it comes to the most important finance problems small businesses were facing. Credit access conditions improved slightly in 2009 compared to 2010 (see figure 10), however remain on a critical level. In 2010 11,8% out of 856 small businesses rank the inability to obtain credit as their most relevant financial challenge. In contrast, “just 3 percent out of 856 of small employers surveyed attempted to raise equity capital in 2010”, underlining their limitations in this field (see chapter 3) and the fact that private business owners are interested in keeping ownership control (Dennis, 2011).

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Figure 10: Credit access conditions for small businesses - 2009 vs. 2010 (Dennis, 2010 & 2011)

4.3 Large and Medium-Sized Businesses

“Based on current market conditions and our financial condition, our ability to effectively access liquidity sources is significantly limited” (Standard Pacific Corporation, 2007). This quote reflects the difficulties even medium-sized and large companies were recently facing in the process of raising funds.

4.3.1 Analysis of Financial Key Performance Indicators and Ratios

As the financial health of a business is not only determined by the individual financial values the relationship among these insights has to be considered as well. The following KPI’s and ratios were selected as they provide insights about the impact of the financial crisis on the respective businesses (see table 2) and outline their counteractions.⁵ Averages across all businesses analyzed are displayed; individual company performance can review in the appendix.

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Table 2: Large and medium sized businesses under examination

Earnings before Interest and Tax

The EBIT illustrates operative business profitability independently from a company’s capital structure and before tax considerations. The indicator has decreased dramatically across both business segments during the financial crisis, underlining the overall industry downturn (see figure 11). From a financial perspective this trend provides an understanding that internal finance has lost its potential as major funding option as no or only marginal earnings were available to be retained as outlined from a theoretical perspective in chapter 3.

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Figure 11: EBIT in Mio. US$ - averaged across all businesses analyzed (Annual Reports, 2006-2010)

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¹ Businesses examined are selected from residential construction only.

² This paper concentrates on the acquisition of monetary resources as this field was strongly affected by the financial crisis.

³ Pros and cons of both alternatives are outlined by Constantinides & Stulz (2003, p.235) and will not be examined in this text as it is rather valuable in this context to point out the impact of the financial crisis on each funding resource.

⁴ Costs: 6-10% of issue volume on average.

⁵ Data was gathered from individual annual reports of the respective businesses. Breakdowns on company level can be accessed in the appendix. As calculations are based on a limited sample results cannot guarantee representativeness.