More energy companies defaulted in the first five months of 2016 than in all of 2015. The volatility of the energy market has made investing in, and working with, energy companies increasingly difficult to manage. Using our proprietary quantitative system to rate the financial health of companies, we analyzed bankrupt vs. non-bankrupt energy companies for the period of 2015 – 2016.
The bad news is that 51% of the US-based energy companies in our coverage, which have yet to default, currently have Very Poor Health - the riskiest category on the Core Health Score (CHS) scale. There will be more pain to come in this space and developing a strategy to mitigate losses is necessary now more than ever.
ENERGY COMPANIES DON’T DEFAULT OVER NIGHT
The good news is that most companies don’t fail overnight. RapidRatings successfully predicted 100% of energy bankruptcies in 2015 with 12-18 months warning prior to default. As the leader in predicting defaults, we use our FHR (Financial Health Rating) to evaluate a company’s financial health – this is comprised of our CHS and Resiliency Indicators. The CHS is a measure of underlying competitiveness, efficiency and long-term sustainability. The Resiliency Indicators include leverage, liquidity and earnings performance factors to provide a specific indication of a company’s short term risk of default. In simplest terms, companies with lower FHRs are far more likely to default than those with higher FHRs. With the rarest of exceptions, companies deteriorate over time and trends in their weakening can often be seen if a broad enough perspective is taken.
COMPARING FAILED ENERGY COMPANIES TO THOSE SURVIVING
The FHR, CHS and median ratio profiles of failed vs. surviving companies in energy over the past 18 months is vastly different. Take a look at these median ratios of energy companies who failed vs. those who are surviving:
- CAPEX/Cash From Operations – Failed companies invested less in capital expenditures than surviving companies, by a significant amount
- Quick Ratio & Current Ratio – Failed companies have significantly lower ability to pay back obligations due to greater liabilities with less assets
- Debt/Tangible Equity – Over half of failed companies had a negative tangible equity. Of those that had a positive tangible equity, failed companies had significantly higher levels of debt compared to tangible equity, which is very hard to sustain
- Interest Coverage – The median of all energy companies had a negative interest coverage ratio, signifying that most companies do not have enough earnings to cover their interest payments. Failed companies had a significantly more negative ratio though, displaying the clear difference between a struggling company and one about to go bankrupt
- Operating Profit Margin – The median of all energy companies had a negative margin. However, surviving companies only had -8% margin, while defaulted companies were 13x worse than that
- ROA & ROE – Failed companies were significantly worse at generating profits from their investments in assets or equity
IDENTIFY FAILING ENERGY COMPANIES WITH EARLY WARNING SIGNALS
There are many different lenses to evaluate the risk of energy companies, but it’s also critical to not be over reliant on any one individual metric, such as debt/equity ratios, as a myopic view can give false comfort and other signals might be missed. Using key financial ratios, the FHR, CHS & our Resiliency Indicators, you will be able to identify companies that have the greatest risk of default with time to act.
The overall decrease in energy companies’ financial health is a backdrop that should make all risk professionals with energy exposure highly attuned to the challenges that lie ahead.
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