Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 191

When a company is a money pit

“Assets collect risks around them in one form or another. Inventory is one risk, and accounts receivable is another risk.” – Michael Dell, founder and CEO of Dell Technologies.

All businesses face the ongoing challenge of generating cash flows in excess of their borrowings. If a business is unable to pay its debts owed, it is no longer a ‘going concern’ and will face reorganisation or liquidation. Nevertheless, profitability is not necessarily a prerequisite for a business’s ongoing survival. A business can keep losing money if investors keep pumping cash back in, often in the vain pursuit of growth opportunities that, for some reason, cannot be funded through existing profitable operations.

Watch for the death spiral

Some businesses may even have the duty to continue unprofitable operations if they need to keep servicing their debt, to the detriment of equity holders. This is the unhappy scenario where excess debt begets excess production and forced sales through reduced prices. Lower prices require higher production volumes to meet the same existing debt burden, and the death spiral continues.

Forced asset selling or ‘deleveraging’ is a variation on the same theme, as is the current predicament of cash-strapped energy producers. While the law of supply and demand suggests that they limit supply to drive up prices, the need for immediate cash flows defies this and ultimately lowers the return on their assets, perhaps changing the nature of the assets in the process.

“We started the company by building to the customer’s order. And, interestingly enough, we didn’t do it because we saw some massive paradigm in the future. Basically, we just didn’t have any capital to mass-produce.” – Michael Dell

Different types of capital and liquidity

Asset values and their power to generate profits are joined at the hip. Some would say that net profits provide the best way to value the assets of a business, since assets are only worth the cash flows they can generate. This is a useful concept, but it overlooks the overall convertibility of the assets, or how they fare in a liquidation scenario. The more capital intensive a business is, the less valuable its capital actually is, all things equal. If invested assets strain to generate profits as a going concern, they will likely strain to achieve satisfactory prices in liquidation. Similarly, the very fact that assets may be relatively liquid would likely prevent their ‘forced liquidation’ in the first place and accordingly, this should be considered when performing valuation analysis.

This points to a duality between the profitability and liquidity of assets as they pertain to the risks of the equity holder. Both imply an ease of converting assets into cash and, in this sense, may act as substitutes for each other in the reduction of equity risk. Equity investors, as a rule, forego the safety of cash to make their investments. To the extent they can get it back, they might have their cake and eat it too.

Recognising this duality can uncover more investment opportunities with a greater skew to positive outcomes. The good ones may be less exciting or glamourous unless you happen to like specialty chemicals or Pachinko balls. They often combine a modest upside with a very limited downside and can be fantastic investment opportunities since, while the equity risk is reduced, the participation in business or economic value-add is preserved.

Some investors bemoan ‘lazy balance sheets’ with excess cash and lower return on assets on paper, but they shouldn’t overlook the downside protection that this liquidity inherently provides. ‘Optimising’ balance sheets by leveraging up to juice equity returns comes with its own risks. Only to the extent that operational and business risks can be eliminated can leverage be safely applied, and history is littered with investors who have gotten this balance wrong, with nothing left to show for it.

"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious," explained Warren Buffett in his 2010 Shareholder Letter. "But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."

Equity investors assume fundamental risks (e.g. the level of borrowings) and should be aware of the relative severity in their investments. If and when prevailing market prices permit them to capture most of the upside they expect from their equity investments, while severely limiting their downside, investing first principles should be the guide. Almost by definition, these opportunities are unlikely to be headline-grabbing growth stories that lead to exciting narratives and visions of the future.

 

Peter Bull is Head of Equities and Nimalan Govender is a Portfolio Manager at Morningstar Investment Management Australia. This article is general information and does not consider the circumstances of any individual.

 

  •   23 February 2017
  • 3
  •      
  •   

RELATED ARTICLES

US shares: Ambitious multiples on ambitious EPS forecasts

banner

Most viewed in recent weeks

Testamentary trusts post-budget: Estate planning, tax reform and the ‘death tax’ debate

Proposed Budget changes to taxation are casting new uncertainty over testamentary trusts, prompting closer scrutiny of estate planning structures and the real implications of reforms still taking shape.

High quality businesses are on sale

Beneath the dominance of the ASX's largest stocks, much of the market has been left behind. High-quality companies are now trading at levels rarely seen, offering opportunities for investors willing to look deeper.

Meg on SMSFs: The CGT changes don’t impact super but what about Div 296 tax decisions?

New CGT rules could tip the scales in the super vs non-super debate. For those facing the Division 296 tax, the case for withdrawing has gotten more complex. A "comparison rate" tool may help assess decisions.

The strange effect of the 30% minimum capital gains tax

The 30% minimum tax on capital gains sits at the heart of the budget's proposed reforms. Yet the mechanics reveal anomalies that introduce unexpected distortions that raise questions about its design.

Welcome to Firstlinks Edition 667 with weekend update

The downfall of the giant and three lessons for investors.

  • 18 June 2026

Ranking three common retirement strategies

The defining challenge of retirement isn't just about building wealth, it's about converting your lifetime savings into sustainable income. A holistic understanding of different strategies can improve long-term outcomes.

Latest Updates

Planning

Does your will qualify for the discretionary testamentary trust exemption?

Treasury has confirmed the exemption many families were hoping for. But buried in the fine print are two conditions that could leave some wills on the wrong side of the exemption, despite years of careful planning. 

Lithium's latest drop and what it means for ASX investors

Lithium's latest sell-off has punished ASX miners as prices remain hostage to shifting expectations. The key challenge is navigating a market prone to extreme volatility despite a strong case for the long-term demand outlook.

Investment strategies

CGT reform and fund turnover: who really feels the impact?

The implications of CGT reform are far and wide. As the 50% discount gives way to inflation indexation, turnover and return profiles may become critical drivers of after-tax performance. Some strategies face a far greater hit. 

Superannuation

Super was built for a very different Australia

Our retirement system was built around assumptions that no longer hold. Lower homeownership, longer lifespans and changing expectations are exposing cracks that policymakers and super funds need to address. 

Retirement

Retirement in reality - 4 months in

Many people spend years planning financially for retirement but little time preparing for what comes next. Four months in, here are the surprising lessons i've learnt on finding purpose, social connection and healthy habits. 

Investment strategies

After the Budget, Australia needs its own definition of quality

As tax reforms reshape investment incentives, investors should rethink what quality investing means in the uniquely concentrated Australian market, where traditional frameworks may not translate as effectively.

Datacenters are the new shale oil

Why are tech giants pouring billions into datacentres when the economics look questionable? The most dangerous words in investing may be: "everyone else is doing it". Today's AI boom has striking parallels with the shale bust.

Sponsors

Alliances

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.