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Audit Point of View

When the River Dries Up, Look for a New Source of Water 

With Financing Scarce, Audit Committees Should Consider Their Role in Helping With Alternative Funding Strategies

 

The mining boom that so recently filled the ears of optimistic analysts is being drowned out by the deflating whoosh of declining commodities prices and resulting caution on the part of investors and lenders. Many Canadian companies have shut down operations, cut back on planned project expenditures and limited capital expansion. There’s no question that it’s necessary to reduce costs now. Yet how many companies have looked at their long-term financing strategy to identify hurdles to accessing future capital, assess how long they can remain competitive given their current available resources, and determine the true cost of doing business going forward?

When the River Dries Up, Look for a New Source
When the River Dries Up, Look for a New Source

 

These questions have not made their way to the top of most board agendas, but they increasingly need to be taken up. Production profiles are dropping and “commodity prices are expected to hold steady—at best—this year, and many are expected to fall,” with Barclays PLC saying they will “remain sluggish for some time to come.” As this could affect the survival of some companies, audit committees may need to get more involved in overseeing the financing issue. They should make sure they fully understand any risks related to the company’s financing structure and take steps to ensure management is effectively evaluating and mitigating them. These are challenging issues in challenging times, but companies that weather the storm will be poised to flourish.

Financing Strategy is Critical to Reducing Risk

With financial risk oversight often one of the audit committee’s primary responsibilities, it must be a priority to ensure that the organization has a financing strategy appropriate for the current risk environment. Financing options have changed significantly, and many mining companies are not on top of that shift. In recent years, they’ve taken advantage of relatively cheap debt, using it to leverage up and finance growth. In a lower commodity price environment, however, they need to both reassess their ability to carry that debt and find alternative ways to finance expansion (and potentially refinance existing debt as well).

 

Mining companies need a robust financing strategy that can account for multiple scenarios, such as black swan events and severe market shifts (what if commodity prices drop by 20%?). Key questions need to be asked and answered: What are our liquidity risks? What steps are in place to manage those risks? What about covenants and the company’s ability to service debt? If we abandon a project because it’s no longer viable, what does that do to the company’s net worth?

 

“Many mining companies are running scenario analyses to understand the impact of sudden shocks on future cash flows, bank covenants and the overall strength of the balance sheet.”

With traditional debt becoming more expensive and equity in short supply and unappealing to companies in a low share-price environment, it’s important—along with asking the right questions—to consider alternative strategic financing options. Is management talking to strategic investors, such as sovereign wealth funds and private equity, as well as potential financial investors? These can be strong options for some companies; it’s critical, however, to fully understand how they may impact the business.

What Can Audit Committees Do Around Financing Risk?

Audit committees can begin by developing a precise picture of the company’s financial situation. Key questions to ask yourself (and in some cases management) include:

 

  • How much room do we have before there is a danger of covenant breaches?
  • If applicable, how are the relationships with rating agencies being handled? Do the agencies understand our company and its risks?
  • Where is our cash being spent?
  • Has management considered multiple scenarios and developed responses?
  • Do we really fully understand the company’s treasury management policies and strategies?
  • Are a full range of alternatives being considered by management?

 

If the company is actively reassessing its business plan to optimize operations, audit committees also need to define whether the business plan will drive financing strategy or vice versa. Will planned acquisitions or expansions create and drive specific capital/financing needs? Or will the company work within recognized capital constraints and manage plans accordingly?

The Financing Issue Isn’t Going to Fade Away

Financing is inherently difficult in a commodity business. Ideally, the company’s financing strategy will let management execute their business plan while retaining the flexibility to be opportunistic in the market. New approaches to financing, such as private equity and sovereign funds, can help, but both executives and directors must understand their implications and impacts. Companies that let financing strategy slide may end up struggling, but those that leverage financing to improve their balance sheets and flexibility can look forward to some great opportunities.

 

  • Todd Buchanan, National Leader, Accounting Advisory Services
  • Lee Hodgkinson, National Industry Leader, Mining

1 International Business Times, January 29, 2014. Copper Prices May Be On The Rise, In Sharp Contrast To The Other Much Duller Commodities Markets. Accessed at http://www.ibtimes.com/copper-prices-may-be-rise-sharp-contrast-other-much-duller-commodities-markets-1550555 on March 12, 2014.

 

2 KPMG. Key Questions for Challenging Times. (2014) Accessed at http://www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/Documents/key-questions-for-challenging-times.pdf [PDF 2.65MB] on March 12, 2014.

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Todd M. Buchanan

Todd M. Buchanan

Partner, National Leader of Accounting Advisory Services

416-777-8847

Lee A. Hodgkinson

Lee A. Hodgkinson

Partner, Audit & National Industry Leader, Mining

416-777-3414

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