Hunting for gold amongst write-downs

A common outcome emerging from earnings announcements this year has been losses arising from write-downs.  Within the US, impairment charges for the first half of 2020 have exceeded $260 bn which is almost 30% higher than the entire amount recorded in 2019.  Moreover, it is on track to exceed the highest for the past 20 years which was in 2008 during the GFC.  Within Australia, there has been a steady stream of companies recording impairments charges across a wide range of industries ranging from energy to construction.  Senior executives will blithely argue that such charges are non-cash and are accounting adjustments driven by the auditors. In other words, there is no impact upon the value of the business.

Lenders to such companies would beg to differ.

A brief explanation about impairment charges. ‘Aggregate future cash flows’ is the commonly accepted tool used to value an asset. Hence, if such cash flows of an asset or independent group of assets (cash-generating unit – CGU) is less than the value on the books, companies are required to write down the book value, i.e. record an impairment charge.

Asset write-downs have several implications.

Firstly, they indicate that the outlook for an operating unit of a business (CGU) is less rosy than what the company had originally believed.  Clearly, that is the reason behind write-downs in the energy sector such as Woodside Petroleum’s massive $4bn write-down and Quanta’s $1.4 bn write-down.

Secondly, a write-down impacts upon the leverage ratio of a company.  For companies that have a high leverage ratio, an asset write-down has significant consequences.  Companies that breach such covenants or at risk of breaching them will be seeking to bolster their capital. While debt refinancing would be the common sense approach, that avenue may be restricted if banks take a pessimistic view of further exposure. Especially so if the write-downs are pervasive within the industry.

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