Debt capital can be costly if managers fail to use it well

Companies can borrow to finance growth, but credit can send a firm into insolvency or death.

On September 23, 2019, for example, Thomas Cook Group went into compulsory liquidation.

The firm was formed in 2007 but its predecessor included Thomas Cook and Son, Thomas Cook AG and MyTravel Group.

The group operated in two separate segments - a tour operator and an airline. The founding company, Thomas Cook and Son, was formed in 1841.

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For a long time, the only credible travellers’ cheque was in the name of Thomas Cook.

This was because of ease of accessibility, safety and worldwide acceptance. It was a firm with 21,000 employees.

On the date it went into compulsory liquidation, there were 600,000 of its customers stranded worldwide, and the United Kingdom had to arrange for repatriation of 150,000 of its citizens stranded abroad.

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Thomas Cook was a case of being too old and too big to fail, yet the airline is no more. The sad story is that the company did not collapse due to lack of customers.

To quote the British press, it did not collapse because people stopped taking holidays.

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The situation is similar to our Kenya Airways, where the planes are up in the air, but there is no cash.

Nils Pratley explained the collapse of Thomas Cook in the context of bad management, banks that are unwilling to take risks, Brexit and stiff competition.

However, the two factors that top in explaining the collapse are bad management and huge debt.

Huge commissions

The most important asset to any business is a quality manager. Excessive use of debt is itself a poor managerial choice.

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Part of the failure is traced to reliance on the travel agency, while most of the bookings can now be done online.

It reminds us of Kenya Airways’ huge booking offices attracting high rents. 

In the UK, it was realised that those who visit booking offices are few and old, over 65 years.

The problem with relying on travel agencies is the long cash flow cycle together with pilferage and huge commissions payable.

 It takes time for the travel agency to submit the ticket proceeds to the airline.

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Weather and politics affect business and Thomas Cook was no exception.

Brexit negatively impacted on the British and other European travel plans, and such uncertainty dampened credit availability from financial institutions.

Fewer people go on holidays when the weather is hostile.

However, quality managers would have effectively responded to the effects of the weather and Brexit. Managers are paid well to manage unexpected factors that dampen the firm’s performance.

However, two factors are outstanding to the collapse of this company. One was the merger with My Travel Group Plc that failed to realise expected cost savings, and the mounting debt. 

This is a case of a firm that used too much debt and collapsed. In 2017, the financial statement of Thomas Cook Group for the period ended September 30 showed a net debt of £389 million (only £40 million in 1917), a surge of 872.5 per cent.

However, even with this increase, the company experienced a loss of £163 million compared to a profit of £9 million in 2017.

Additional flexibility

Even with such a high debt, the free cash flow was negative.   

It is worth noting that even with operating losses, the management was optimistic about the firm’s profitability to improve.

During the same period, the management remarked that “while the net debt is higher than previously forecast, the lenders remain supportive, and we have secured additional flexibility to ensure we continue to deliver the strategic plan.”

However, the firm had to pay £124 million as interest on cash borrowed. With negative free cash flow, the company had no money for further investments.

Managers must learn how to use debt capital well in financing their operations. Debt, even at zero interest rates can send any firm into a situation it may not pay its bills and debt.

This happens when the value of assets goes down while the amount of debt is constant because the amount borrowed is contractual.

The answer to the cost of debt is in John Tobin’s new theory on debt and interest rate.

It is Tobin’s contention that the standard economic argument that it is demand and supply for money on its own that determines the interest rate, is questionable.

Thomas Cook was faced with falling asset values that were exposed to the debt crisis.

Asset values rise in response to an increase in revenue that the assets generate. The more the revenue, the easier it is to service debt obligations.  

-The writer teaches at the University of Nairobi

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