How Near the Edge? Gauging Lodging Firms' Liquidity

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1 Y How Near the Edge? Gauging Lodging Firms' Liquidity Hotel companies" ability to manage capital will be critical for the foreseeable future. Here's a method for estimating liquidity by Gene Swanson LIQUIDITY IS an overriding concern for hotel companies. The firms that prosper in the present environment will likely be those that have made the most of their financial resources. In this article, I will review the basic requirements of an ideal measure of liquidity, examine the limitations of traditional measures, and consider the liquidity positions of several hotel firms as measured by a new, theoretically appealing measure. For a liquidity measure to fulfill the purpose of giving management an accurate indication of a firm's ability to meet liquidity demands, it must meet these six criteria: (1) It should be derived from the probability that the firm will be able to meet its demands for liquidity; (2) It should explicitly incorporate an estimate of uncertainty; Formerly a visiting assistant professor at the CorneU University School of Hotel Administration, Gene Swanson, Ph.D., is an assistant professor at the Sellinger School of Business at Loyola College in Maryland. He was assisted by the following financial-management students: Petra Beyer, James A. Branch, Marc D. Joseph, Lucy F. Kunkel, Herbert L. Kyzer, Linda K. Marsee, Joseph M. Mastrianna, Colleen M. McCabe, Maui C. Meyer, Joseph M. Miller, and Jennifer M. Sammarco. DECEMBER

2 Emery's Lambda: The Derivation The Lambda measurement is derived from a mathematical model that is based on the following three assumptions: (1) The firm's liquidity can be assessed over a specified time period (or analysis horizon); (2) The firm's liquid reserve is supplemented by positive cash flow and depleted by negative random net cash flows; and (3) The firm's liquid reserve fluctuates randomly. The probability that the firm's liquid reserve will be exhausted before the end of the planning horizon (time T) is expressed by the following formula: Prob.[Z< - ~.] + Prob.[Z<-(L -~T) ] -.~y 2pLo ] e[-~- Where Z is a standardized normal random variable, and ~, (Lambda) = (Lo + t~t)/~ ~--; Lo = initial liquid reserve; I~ = mean net cash flow; = standard deviation of net cash flow; T = length of analysis horizon; and e = base of the natural Iogarithm.--G.S. (3) It should afford management the flexibility to change the time period used in the analysis to be consistent with a particular planning horizon; (4) It should include only the shortterm assets and liabilities that can readily be converted to cash with little loss of value and minimal disruption of daily operations; (5) It should include all potential sources of liquidity (such as lines of credit); and (6) It should incorporate future cash flows as sources of or drains on liquidity, as appropriate.1 Deficient Measures Traditional measures of liquidity (e.g., those related to working capital position, capital structure, ability to cover debt service) fail to meet the six-way test. Most are not developed from solid finance and probability theory, so they cannot ~Gary W. Emery, "Measuring Short-Term Liquidity," Journal of Cash Management, July/August assign probabilities to the likelihood of insolvency. Since they fail to account for uncertainty and are not developed from a rigorous theoretical base, it is impossible to determine their significance with a high degree of confidence. Moreover, their lack of flexibility in measuring the firm's position across different time horizons is a serious shortcoming, especially when applied in a seasonal business environment. Traditional financial ratios calculated from published financial statements may simply document the historical adequacy of the firm's reserves, without giving an indication of the future. Traditional measures by themselves have no economic significance. There's no way of assessing whether a ratio of, say, 2.0 is better than 1.0 or even 0. Emery's Lambda In a 1984 work, Gary Emery developed a liquidity index that overcomes the deficiencies of most current measures. Emery's index, which he designated as Lambda, is a "formula for the likelihood that a firm's liquidity position will reach zero--that is, that it will become temporarily insolvent before the end of the analysis horizon." The derivation of Lambda is beyond the scope of this article, but its application is intuitively appealing and easy to use. For our purposes, Lambda is defined as the sum of the initial liquid reserve plus the total anticipated cash flow divided by the uncertainty about net cash flow. All of these factors are calculated for the time period being analyzed. "Initial liquid reserve" is all sources of liquidity--namely, cash, marketable securities, and lines of credit. The "uncertainty factor" is measured by the standard deviation of net cash flows. A typical time horizon might be a year, but any time period can be used. Lambda is essentially a coverage ratio that compares sources of liquidity to potential requirements. Think of it as a measure of a firm's ability to bring all resources to bear on unexpected demands for cash. The higher the value of Lambda, the more able a company is to meet such demands for liquidity and the less likely the firm is to experience temporary insolvency. In addition to being theoretically pleasing, Emery's index has been verified by rigorous empirical testing. Lambda is a relatively new tool that gives an estimate of the likelihood that a firm will experience a liquidity crisis over some time period of interest. This matter is of real concern to, for example, bankers, employees, suppliers, and others who grant an operation credit. Conceptually, it could also be used by a hotel company to determine whether to sell large room blocks on credit to commercial customers. According to a description in Lotus magazine, the oil company 68 THE CORNELL H.R.A. QUARTERLY

3 Amoco already uses Lambda, as follows: Ron Lyons, a supervisor of credit administration at Amoco, uses Lambda to help evaluate the wholesalers and large institutional customers that buy Amoco's natural gas on credit. The only problem in using Lambda as a credit check, Lyons reports, is getting cash-flow numbers from private companies. But "once we've gotten that information," he says, "the model has accurately portrayed [the company's liquidity status]." Lyons recounts the credit history of a large, institutional customer that nearly went bankrupt. After learning about Lambda, Lyons conducted an analysis of the customer's cash flow. Early in the relationship, the customer's Lambda was healthy--9 or better-- but it deteriorated steadily as the customer's financial hardships piled up. At the time of a publicly threatened bankruptcy filing, the customer's Lambda was a sickly In statistical terms, Lambda is a Z-statistic from which the probability of a firm's bankruptcy can be assessed. No such probability can be obtained using current or quick ratios. Moreover, inferences from these ratios must necessarily be subjective. Financial Ratios in the Lodging Industry Compared to other industries, the lodging industry's working-capital position is low. The current portion of long-term debt is relatively high, while inventory and accounts receivable are lower than many other industries. Because hotels are labor intensive, they experience a high liability for accrued wages payable, and hotels have a relatively short cash-flow cycle that reduces the level of current assets. The heavy use of debt financing that characterized hotel development in the 1980s is certainly 2Kelly R. Conatser, "Can You Pay the Bills?," Lotus, January 1991, p. 31. Liquidity Ratios A Primer of Financial Ratios Current = current assets / current liabilities Quick = (current assets - inventories) / current liabilities Liquidity ratios measure the firm's ability to meet such short-term obligations as payroll, rent, and utilities. The higher the ratio, the better able the firm is to meet currently maturing obligations. Capital-Structure Ratio LT Db/Eq = long-term debt financing / owners' or common-shareholders' equity in the firm This ratio is a measure of the degree to which the firm's assets are financed by various stakeholders--in this case, those who have supplied long-term debt and common equity. It may also be considered a type of liquidity measure, since the higher the firm's relative indebtedness, the more likely it will have liquidity problems at some point in the future. Debt Management Interest Coverage = earnings before interest and taxes / interest charges This ratio is also called the "time-interest-earned" ratio. It is a measure of the firm's ability to cover long-term interest expense from its normal operations. The higher the ratio, the less likely a liquidity crisis may occur.--g.s. understandable, in view of the decreased cost of debt. Nevertheless, the reliance on debt financing eroded interest-coverage ratios and increased loan-to-value ratios. As industry profitability declined during the end of the last decade, many individual properties had trouble servicing that debt. Seven Firms In the spring of 1990, my associates and I analyzed the liquidity ratios for seven hotel companies: Divi Hotels, Hilton Hotels, Holiday Corporation, La Quinta, Marriott, Motel 6, and Prime Motor Inns. With the advantage of hindsight, it is possible to see how effective the Lambda measure was in determining each company's health. Divi. Divi Hotels, based in Ithaca, New York, operates several resorts in the Caribbean and is a Ramada franchisee. A cursory examination of Divi's traditional financial ratios gave no cause for alarm, but its debt ratio betrayed a substantial increase in reliance on debt financing. Its long-term debtto-equity ratio rocketed from 0.66 in 1984 to 3.13 in A close inspection of the firm's Lambda measure shows that, while the firm appears solidly liquid, the company is increasingly propped up by lines of credit. Such a reliance on lines of credit, rather than earnings, raises a cloud over the financial health of any firm. Even though Divi's 1989 cash flow was a negative $4.50 million, the firm remained solvent--not a surprise, since its Lambda score was a respectable However, if the company's lines of credit had evaporated in 1989, the likelihood of insolvency would have gone from zero to 60 percent. Divi's public stance at the time was that its fortunes would turn around in 1990, but that was before Hurricane Hugo demolished one of its Caribbean resorts. Likewise, 1991 has been a difficult year for resort operators dependent on U.S. travelers. The price of the DECEMBER

4 La Quinta's debt-coverage ratio plummeted in Was this a firm on the brink of financial disaster? Not at all-- because it had a stable and predictable cash flow. company's stock was badly bashed, and a proposed deal for Groupe Accor to purchase some of the firm's Caribbean resorts fell apart. More recently, creditors forced out the company's management. Hilton. Hilton's financial ratios were above the sample average, but they showed a trend of deterioration. The firm's current working capital ratio fell from over 3.0 in 1985 to just over 1.0 in 1989, and Hilton's interest-coverage ratio also eroded over the three years prior to Unlike many hotel companies, however, Hilton did not appear to be over-leveraged. It had a stable, conservative mixture of debt and equity, and its leverage ratio was well below the average for the seven firms in this study. Was Hilton's cash position actually deteriorating? An analysis of its Lambda measure indicates that the answer is no. The firm's solvency position was strong and actually improved relative to the sample average, especially in Hilton increased its line of credit by fivefold during the period of our study. One explanation is that the firm gradually implemented a more cost-effective and aggressive working-capital policy beginning in The average value of Lambda for Hilton increased markedly during this study--from in 1984 to in The increase in Lambda reflects the expansion of the firm's credit line from $82.5 million to $460 million in the same period. It appears that Hilton was carrying excess liquidity (possibly a function of the battle over its stock ownership). Since access to liquidity involves expense, Hilton might better increase its return by managing its shortterm accounts more aggressively. Holiday. Before its division into Promus Corporation and Holiday Inns, Holiday Corporation's working-capital ratio was stable, but below the average for this sample. The company's interestcoverage ratio showed a steady decline from 3.65 in 1984 to 1.63 in The long-term ratio of debt to equity eroded substantially from 0.77 in 1984 to a negative 3.17, as a consequence of the company's borrowing money in 1987 to pay a special, one-time dividend of $65.00 per share. The pay-out, an action taken to discourage a hostile corporate takeover, resulted in the firm's having a negative equity position in 1987 and Holiday's Lambda measure reflected the poison-pill action-- ballooning to as a result of the large credit line established to cover potential difficulties of recapitalization. With the exception of 1987, Holiday's Lambda score was a stable and its line of credit a steady $ million during the study. The firm appears to have had a liquidity strategy consistent with prudent short-term financial-management practices. To its credit, Holiday's pool of liquidity was supported both by fundamental earnings and a judicious use of credit lines. La Quinta. Like Holiday, La Quinta's working-capital and debtcoverage ratios declined during the period of this study. Indeed, the firm's coverage ratio, always below the sample average, sank to a meager 1.16 in 1989, meaning that La Quinta had just barely enough cash to service its debt. Was this a firm on the brink of financial disaster? Not at all--the Lambda measure shows that La Quinta was the most liquid of all the firms in the sample, because it had a stable and predictable cash flow. Having a cash flow that could be estimated with a high degree of confidence, La Quinta did not need to hold large cash reserves. This case shows how Lambda analysis may lead to different managerial decisions than the use of tradi- 70 THE CORNELL H.R.A. QUARTERLY

5 tional accounting measures. La Quinta pursued a strategy of earnings stability. With the smallest standard deviation in its cash flows, La Quinta had the largest overall Lambda score, averaging Such a large score indicates that the firm had excess liquidity and could have implemented a more aggressive shortterm financial-management policy. Marriott. During the late 1980s, Marriott's working-capital ratios remained stable. Although they were below the average for this sample, it appears that this finding is the explicit result of an aggressive working-capital policy. A troubling trend developed between 1984 and 1989, however, as the firm increasingly relied on long-term debt financing. Marriott's debt-to-equity ratio increased eightfold, from 0.62 in 1984 to 5.23 in Marriott's interest-coverage ratio in the same period dropped from 4.83 to 2.89, but that figure remained above the average for the sample. Analysis using the Lambda measure shows, however, that Marriott was in no danger of insolvency, despite the huge debt, as long as its lines of credit remained open. The firm had $1.2 billion in lines of credit in 1988 and 1989, and a Lambda score of indicated virtually no chance of insolvency in In short, Marriott was very liquid. Even in the most pessimistic of possibilities (a cashflow of zero and a complete loss of credit lines), Marriott's likelihood of insolvency is just 5 percent. In 1991, Marriott is suffering along with the rest of the industry, but it should remain liquid. Motel 6. Motel 6 operated with extremely low working-capital ratios. Under traditional analysis, that would imply a poor liquidity position and financial weakness. In Motel 6's case, however, the low ratios reflected an aggressive and cost-effective policy of short-term financial management. Rather than keep current assets at relatively large levels to cover current liabilities, Motel 6 used concentration banking, disbursement systems, and credit lines as sources of financing, thereby minimizing the amount of cash and marketable securities required. Motel 6's rapid expansion in the late 1980s was financed largely by debt, as shown by the increase in its debt ratio from 1.73 in 1986 to 5.27 in Its ability to service that debt remained below the average for this sample. During 1986 and 1987, the coverage ratio was negative, and in 1989 it was a scant By traditional measures, Motel 6's liquidity position appears weak, but its Lambda scores were healthy: 7.15 in 1988, 5.51 in 1989, and an estimated 3.19 in The firm's large expansion clearly put a strain on corporate resources, but the company remained liquid. The sources of the deterioration are two. First, the firm's cash flow dropped substantially in 1990, compared to Second, Motel 6's line of credit was nearly halved between 1988 and (That may have been the result of a deliberate policy of maintaining the smallest possible credit line.) Although the decline in Motel 6's Lambda score in 1990 may have been a one-time event, the industry's continued softness weakened the company's liquidity. Groupe Accor's purchase of Motel 6 appears well-timed for both firms. Accor obtained a solid hotel brand that was still in good financial shape, while Motel 6 gained access to enough liquidity to continue its expansion into its only remaining untapped U.S. market, the northeast, and also into Canada. Prime Motor Inns. A discussion of Prime Motor Inns is clouded by the fact that the company does not disclose information about its lines of credit. For the purpose of this article, I assumed that the company had none. Even without a credit line, however, Prime was quite liquid in 1989 compared with the other firms in this sample. But 1989 may have been the watershed year for Prime, as a steady increase in cash flow recorded in the period of 1984 to 1989 stalled in Moreover, 25 percent of its income in those years came from such one-time gains as hotel sales and consulting fees? Prime's common stock lost about 80 percent of its value in , and Standard and Poor's placed some $230 million of Prime's subordinated debt on its surveillance list. In short, Prime appeared to be in trouble. Ironically, Prime had the highest working-capital ratio in the sample. During this same period, Prime's Lambda score was among the lowest in the sample. The reason for this liquidity weakness was that the standard deviation of its cash flow was uncomfortably large. The firm's cash flow increased at a rapid rate during the period of this study, so its standard deviation is large. By rights, one should expect that Prime's cash flow would increase, but one's confidence in that prediction is low because of the size of the standard deviation. Liquidity Management The challenge of the 1980s was managing and financing rapid, unsustainable growth. The '90s, in contrast, will likely be a decade of effective liquidity management. A measurement like Emery's Lambda will give money managers and other stakeholders a way of analyzing their firm's financial performance. :~Brian Bremner, "Prime Motor Inns Is Short on Cash, Long on Hope," Business Week, July 23, DECEMBER