The ongoing financial shock brought on by COVID-19 has hit the corporate sector unlike any other in modern times. Oxford Economics estimates a 12% decline in GDP in the first half of 2020 in the United States, a loss three times greater than during the 2008 financial crisis and the greatest economic contraction since 1946. COVID-19 is not only an immense public health trauma but a unprecedented financial shock as well. Both supply and demand are impacted with the almost complete elimination of foreign and domestic demand, while production, capital, and labor have similarly disappeared.
The pandemic-induced financial disruption has significant effects on the supply chain, and vice versa. Orders are cancelled or businesses are unable to pay invoices upstream, with cascading effects downstream throughout the supply chain. Firms with the ability to withstand the shock are already reassessing their supply chain, while many businesses will simply cease to exist. While there are numerous factors that contribute to financial risk; liquidity, solvency, and exposure are among the most impactful to a company’s overall financial risk and are especially informative during these exceptional circumstances.
Having cash on hand is foundational under normal circumstances but becomes essential to resiliency when revenue streams disappear. A core component of financial risk is assessing which businesses have enough reserves to make it through the year. There are a range of assets a business can hold, such as patents, property, or inventory. Liquidity captures the ability of a business to turn those assets into something you can spend. In short, as Columbia Business School professor Donna Hitscherich notes, “cash gives you time, you can think about your higher-order needs, rather than just survival.”
As in previous crises, there is already a shift to shorter-term commitments, with loans largely doled out to high-rated companies. Companies are trying to free up cash and are cancelling dividends and share buybacks. Based on a recent survey by the Association for Finance Professionals, preserving cash is a top priority, with 61% of organizations freezing hiring, and 70% have either delayed capital expenditures or are in the process of delaying them.
As the graph above demonstrates, there are numerous, additional factors that impact corporate liquidity, some of which can even be outside their control. For instance, in countries with higher inflation rates, businesses are less likely to keep large cash reserves. Also, the impact of the specific industry or sector a business is in cannot be overstated, which we are already seeing with plant closures and massive oil market disruptions.
While cash on hand is a priority, the ability to pay off existing debt arguably poses even more existential challenges as businesses seek ways to remain viable during this crisis. There are already signs that many well-known names are considering bankruptcy, indicative of a broader trend over the last decade (see graph below) of accumulated debt.
This growth in debt has given rise to ‘zombie companies.’ While definitions vary, these are generally firms that do not have the earnings to cover their interest debt and therefore issue new debt to stay viable. Today, roughly 16% of American firms are zombie firms and are the core contributors to the large debt figures in the graph above. Zombie companies are not unique to the United States; China’s 300% debt to GDP rate is partially due to these firms, and last year approximately 13% of firms across the globe were considered zombie firms. By comparison, in 1990 this rate was 2%. As one expert
Exposure & Market Trends
With a global contraction expected to reach historic levels, there are additional indicators across the financial ecosystem that significantly impact a firm’s financial risk. Among these are the industry a business is in and geography, as demonstrated in the first figure. For instance, South Africa’s credit rating was moved to junk, while Canada’s was downgraded due to the oil crisis. While the impact of a country’s credit rating on a specific firm varies country to country, it does factor heavily into some firm’s ratings, especially in emerging markets.
These emerging markets are especially vulnerable to systemic shocks – such as a pandemic. As the chart below illustrates, emerging markets have experienced significant capital outflows during the pandemic, with the impact varying significantly country to country. To halt this exodus, which has already been coined the COVID cliff, there could be a return to capital controls in many of these markets. Just as the pandemic has halted the movement of goods, services, and people, the same may begin to be true for capital in certain markets.
Financial shocks will continue to pose a major risk to businesses throughout and following the ongoing crisis, with wildly divergent outcomes for different organizations. To weather them, companies should first focus on the fundamentals. As one financial manager noted, “Companies should, most importantly, have balance sheet strength to manage through a protracted shutdown.” Pre-COVID levels of liquidity and solvency are significant indicators of whether a business can withstand this uncertainty.
Second, governments across the globe are taking unprecedented steps to mitigate the sweeping impact of the pandemic. For instance, as the pandemic spreads across Latin America, with Guayaquil, Ecuador the hardest hit so far in the region, there are a range of relief programs being implemented and many that are well-underway. These interventions tend to focus on market liquidity and preparation for upcoming bankruptcies. Across the pond, the U.K. is relaxing their insolvency laws to help their businesses remain viable. The efficacy of the various governmental actions here and globally will impact financial risk and stability.
Finally, financial risk mitigation relies heavily on preparing supply chains for the changed world. As noted above regarding debt chains, the financial risks posed up and downstream a supply chain propagate throughout the entire network of dependencies. Maintaining better visibility and going deeper across the extended global supply chain will be key to mitigating financial risk as this crisis evolves.
The Interos platform monitors financial risk to assess its impact on extended enterprise supply chains. We are committed to continuing to monitor COVID-19 -driven upheaval and providing insight for businesses searching for the path to economic recovery and adapting to the “new normal.” The next piece in this series will focus on the operational disruptions to supply chains, and how COVID-19 is impacting these risks.
Dr. Andrea Little Limbago is a computational social scientist specializing in the intersection of technology, national security, and society. As the Vice President of Research and Analysis at Interos, Andrea leads the company’s research and analytic work regarding global supply chain risk with a focus on governance, cyber, economic, and geopolitical factors. She also oversees community engagement and research partnerships with universities and think tanks and is a frequent contributor to program committees and mentorship and career coaching programs. She has presented extensively at a range of academic, government, and industry conferences such as RSA, SOCOM’s Global Synch, BSidesLV, SXSW, and Enigma. Her writing has been featured in numerous outlets, including Politico, the Hill, Business Insider, War on the Rocks, and Forbes. Andrea is also a Senior Fellow and Program Director for the Cyber and Emerging Technologies Law and Policy Program at the National Security Institute at George Mason and a Fellow at the Atlantic Council’s GeoTech Center. She is an industry advisory board member for the data science program at George Washington University, and is a board member for the Washington, DC chapter of Women in Security and Privacy (WISP). She previously was the Chief Social Scientist at Virtru and Endgame. Prior to that, Andrea taught in academia and was a technical lead at the Joint Warfare Analysis Center, where she earned the Command’s top award for technical excellence. Andrea earned a PhD in Political Science from the University of Colorado at Boulder and a BA from Bowdoin College