COVID-19’s impact on the financial health of Canadian businesses: An initial assessment

Introduction

The COVID‑19 pandemic has created a challenging environment for many businesses in Canada. We offer an initial assessment of the impact of the pandemic on the financial health of non-financial corporations.

Our key findings:

  • Bold policy measures have helped many businesses manage cash flow pressures despite substantial falls in revenues. Consequently, insolvencies have remained low and default risks appear broadly contained.
  • Overall indicators of financial vulnerabilities in the business sector have not yet deteriorated. Nevertheless, the pandemic has had an uneven impact on firms. Small businesses and firms in high-contact service industries have been particularly hard hit. Our simulations point to a continued uneven recovery, with some firms increasing their cash holdings while others accumulate debt.
  • The extraordinary financial support provided to businesses over the past year makes it difficult to draw definitive conclusions about the underlying financial health of the sector. It is not clear, for instance, whether some firms will be financially viable once support programs have run their course. As a result of this uncertainty, a risk of a large and sudden increase in corporate insolvencies remains.

The pandemic is ongoing, and the situation evolves daily. The Bank of Canada will continue to monitor the financial health of businesses and report notable developments on its Financial System Hub and in the Financial System Review.

Policy actions helped businesses manage cash flow pressures

The pandemic had an uneven impact on businesses and led to a substantial reduction in revenues for many firms. For instance, according to the Canadian Survey on Business Conditions, over 60 percent of firms experienced a decline in revenues in 2020 relative to 2019.1 Nearly one in three businesses registered a revenue drop of 30 percent or more over the same period. These declines were sharpest for small businesses and firms in high-contact services industries (Chart 1).

Falling revenues imply that businesses are generating less cash than they were previously. Less cash coming into the business can make it harder for them to pay their bills. During the pandemic, government support programs have helped businesses manage these cash flow pressures. At the federal level, the main programs include:

  • the Canada Emergency Business Account (CEBA), which offers subsidized loans to small businesses
  • the Canada Emergency Wage Subsidy (CEWS)
  • the Canada Emergency Commercial Rent Assistance (CECRA) and its replacement the Canada Emergency Rent Subsidy (CERS)

Use of these programs has been widespread, especially within highly affected industries such as accommodation and food services (Chart 2).2

Chart 1: Many firms in the service sector experienced a large drop in revenues as a result of the pandemic

Chart 1: Many firms in the service sector experienced a large drop in revenues as a result of the pandemic

Distribution of changes in business revenue, by industry

Source: Statistics Canada Last observation: December 2020

Chart 2: Firms in hardest-hit industries made greater use of government programs to manage cash flow pressures

Note: Program information reflects data as of September 18 for CEBA, September 28 for CEWS and September 2 for CECRA.
Sources: Statistics Canada and Bank of Canada calculations Last observation: September 2020

Lower borrowing rates have also helped businesses manage cash flow pressures by reducing the amount of cash required to make interest payments. When market stresses emerged at the onset of the pandemic, the Bank launched a series of liquidity facilities and asset purchase programs. These facilities and programs helped restore market functioning and ensured monetary policy actions could pass through to the economy.3 As a result, interest rates that major banks charged on new and existing loans declined to new lows in the spring of 2020 (Chart 3) and have remained relatively stable since. Similarly, yields on corporate bonds have been below pre‑COVID‑19 levels. The Bank’s Senior Loan Officer Survey (SLOS) also suggests that lending conditions for businesses have remained generally favourable during the pandemic.4 This contrasts sharply with the tightening of credit conditions observed during the global financial crisis of 2008‒09.

Chart 3: Borrowing rates declined in the spring of 2020 and have remained low

Note: Major banks in this chart represent Canada's six largest banks, legally designated as domestic systemically important banks (or D-SIBs).
Sources: Office of the Superintendent of Financial Institutions and Intercontinental Exchange Bank of America Merrill LynchLast observation: February 2021

Businesses have borrowed modestly from financial institutions to manage cash flow pressures. The increase in bank loans observed in March dissipated as financial market conditions normalized and government support programs were launched. Large firms drew on their credit lines when financial markets were strained, but they repaid some of this debt and issued bonds as market conditions improved (Chart 4). The resulting decline in bank loans in the second quarter of 2020 was mostly offset by government loans to small businesses through CEBA (Chart 5).

More recently, signs are increasing that demand for traditional sources of credit is picking up. The SLOS shows that credit demand from small businesses rose notably in in the fourth quarter of 2020, the first increase seen since the start of the pandemic (Chart 6). Some lenders noted that firms are borrowing for short-term operational needs and that they continue to look for ways to increase productivity.

Chart 4: Bank lending increased sharply in March 2020 but fell as bond issuance picked up

Note: Loan data include mortgage and non-mortgage loans from all lenders to non-financial corporations. Debt securities include both long-term bonds and short-term securities issued by non-financial corporations.
Source: Bank of CanadaLast observation: September 2020


Chart 5: Governments became the key supplier of additional loans to firms

Source: Statistics Canada Last observation: 2020Q4


Chart 6: Small business demand for credit increased in the fourth quarter of 2020

Note: Balance of opinion means the percentage of respondents reporting an increase in the demand for credit minus the percentage reporting a decrease in the demand for credit.
Source: Bank of Canada Senior Loan Officer Survey Last observation: 2020Q4

The business sector’s balance sheet is strong, and insolvency risks appear contained

The business sector’s balance sheet has remained strong throughout the pandemic. One way to see this is by monitoring the recent evolution of financial vulnerability indicators, such as leverage and liquidity (Davydenko 2013; Fortier-Labonté 2021). Leverage, typically measured by the debt-to-asset ratio, refers to how much debt a firm is using to finance its assets. The more debt a firm uses, the more likely it will face cash flow pressures if its revenue were to decline. Liquidity refers to a firm’s ability to meet its financial obligations with its most liquid assets. We measure liquidity using the cash-to-debt ratio. The more cash a firm has relative to debt, the less likely it will face cash flow pressures if its revenue were to decline. For the entire non-financial corporate sector, leverage has increased slightly while liquidity has improved notably over the course of the pandemic. These developments confirm that the balance sheet of the business sector has held up well so far (Chart 7).

Looking at individual components of the balance sheet, we note a marked rise in cash holdings. These stood about 28 percent (or $150 billion) above pre-pandemic levels as of the fourth quarter of 2020 (Chart 8).

Chart 7: The business sector's balance sheet has held up well

Source: Statistics Canada Last observation: 2020Q4


Chart 8: Total cash holdings have increased substantially

Chart 8: Total cash holdings have increased substantially

Change in various components of corporate balance sheets, 2019Q4 to 2020Q4

Source: Statistics Canada Last observation: 2020Q4

Although total cash holdings have increased, the impact of the pandemic has been uneven and cash accumulation has varied significantly at the firm level. An example of this variation is the changes in cash holdings across publicly traded firms (Chart 9).5 Roughly one-half of publicly traded firms have drawn down their cash balances while the other half have been growing their cash balances. However, the vast majority of the total increase in cash holdings is in 10 percent of firms. Firms in this category include those in utilities, telecommunications, mining (particularly gold) and parts of retail (e.g., grocery, convenience and some big box stores). The largest declines in cash holdings were mainly among firms in the oil industry.

Chart 9: Changes in cash holdings among publicly traded firms have been uneven

Sources: Compustat and Bank of Canada calculations Last observation: 2020Q4

Due to loan deferrals offered by financial institutions as well as the extraordinary government support measures, the number of businesses in severe financial difficulty has been exceptionally low. In fact, the number of firms filing for insolvency, including proposals and bankruptcies, declined by nearly 25 percent in 2020 relative to 2019 (Chart 10).6 The share of non-performing loans was also low and well below levels observed during the 2008–09 financial crisis (Chart 11).

Chart 10: The number of businesses filing for insolvency declined by nearly 25 percent in 2020

Source: Office of the Superintendent of Bankruptcy via Haver Analytics Last observation: December 2020


Chart 11: The share of outstanding loans to firms unlikely to make payments has remained low

Sources: Office of the Superintendent of Financial Institutions and Bank of Canada calculationsLast observation: 2020Q4

Forward-looking indicators suggest that default risk appears broadly contained. Major banks’ provisions for credit losses on currently performing business loans are an indicator of the banks’ assessment of potential loan losses in the future. These provisions spiked in the second and third quarters of 2020 but have largely normalized since then. In fact, banks have started to claw back some of the loan-loss provisions they incurred during the initial phase of the pandemic (Chart 12). This suggests that although impairments could increase, banks are comfortable with their existing allowance position. They do not expect material increases in credit losses beyond what they have already provisioned for. For large publicly listed firms, market-based measures of “distance to default” deteriorated in late March and early April of 2020 and have also since recovered (Chart 13).7 This improvement is visible across all industries, although most have not yet fully recovered to pre-pandemic levels. Market-implied default risks appear most pronounced in the oil industry.

Chart 12: Provisions for credit losses on performing loans have started to unwind

Source: Office of the Superintendent of Financial Institutions Last observation: 2021Q1


Chart 13: Market-based measures of default risks are back near pre-pandemic levels

Note: Values close to zero indicate a high probability of default.
Sources: Refinitiv and Bank of Canada calculations Last observation: March 22, 2021

Vulnerabilities and risks the Bank is monitoring

COVID‑19-related risks to financial stability appear to have been contained, but financial vulnerabilities could grow during the recuperation phase of the recovery. Non-financial corporate debt was at an all-time high in Canada at the onset of the pandemic, having grown rapidly in the preceding few years. Although indebtedness vulnerabilities were not broad-based across industries, this issue warrants continued monitoring.8

Firms that have stayed afloat by borrowing, either from financial institutions, financial markets or the government, may become far more indebted than they were previously. This development can lead to debt overhang and become a broad macroeconomic issue if elevated debt levels discourage firms from taking on profitable investment opportunities (Myers 1977).9 Such behaviour can slow the restoration of firms’ balance sheets and keep vulnerabilities elevated.

To assess the possibility of future debt-induced vulnerabilities, we use a microsimulation model. The model projects an individual firm’s cash flows consistent with a macroeconomic projection.10 For firms that spend more cash than they earn in any given quarter, we assume they first draw down any cash they have on hand. Once cash reserves are exhausted, these firms raise new debt to continue to finance operations. They will then increase their leverage over the simulation horizon. Conversely, for firms generating more cash than they spend, we assume they use the difference to build up their stock of cash. These firms will deleverage over the simulation.11

Simulation results show that firms in the hardest-hit industries are likely to become more financially vulnerable, while firms in other industries are likely to continue building cash reserves. Assuming the simulated funding needs calculated above are indeed fulfilled with borrowed funds, and that existing debt is rolled over, we can simulate the distribution of firm leverage. In this scenario, the right tail of the leverage distribution—representing highly indebted firms—would increase (Chart 14 and Table 1). However, we also foresee a rise in the share of firms at the lower end of the leverage distribution (low-debt firms). These firms do not face a funding shortfall and therefore accumulate cash over the simulation horizon. Overall, the simulated leverage distribution has more businesses with low leverage and more businesses with high leverage. The median leverage ratio decreases slightly from 0.63 to 0.59.

Chart 14: Simulations suggest that firm leverage could become more polarized as the pandemic persists

Sources: Statistics Canada and Bank of Canada calculations Last observation: 2020Q3

Table 1: Highly indebted firms could gain prominence in Canada’s business sector in 2021

High-leverage firms’ share of:* 2020Q3 (actual, percent) 2021Q4 (simulated, percent)
- number of firms 12.5 16.6
- total liabilities 14.3 19.7
- total wages 7.8 10.7
- total revenues 6.6 8.9

*High-leverage firms are those with a leverage ratio above 1.

A potential risk in the near term is an unexpectedly large and sudden increase in corporate insolvencies once government support programs run their course. The extraordinary financial support provided to some firms over the past year makes it difficult to get an accurate read of the financial health of businesses. In particular, it is not clear whether firms that currently benefit from financial support are financially viable without these programs.

Another risk relates to the potential rise in the number of zombie firms. For instance, the decline in the number of business insolvency filings despite the large economic downturn may indicate a potential further “zombification” of firms in Canada (Chart 15).12 These zombie firms could weigh on economic performance because they are less productive and because their presence reduces investment and employment by more productive firms (Banerjee and Hoffmann 2018).

Chart 15: The number of zombie firms in Canada has risen in recent years

Note: The broad definition identifies a zombie firm as old and persistently unable to generate enough income to make its interest payments. Under the narrow definition, a firm's profitability must also be expected to remain weak in the future. See Grieder and Ortega (2020).
Sources: Compustat and Bank of Canada calculations Last observation: 2020Q4

Finally, while the evidence to date suggests government support programs have helped many businesses manage COVID‑induced cash flow pressures, two caveats are worth noting:

  • The pandemic is not over yet. The business sector will continue to face challenges as authorities further adjust public health guidelines based on the trajectory of the virus. Some firms that managed to stay afloat thus far may see their financial health deteriorate as the pandemic persists.
  • Timely data on the financial health of small firms are lacking. Unlike large corporations, which are required to publish quarterly financial statements for stakeholders, smaller firms often only disclose financial information annually, when they submit their tax files to government authorities. Therefore, data on the financial health of small and medium-sized enterprises during the pandemic will be made available to researchers only in an anonymized format and with a substantial lag. Statistics Canada estimates of real output and hours worked by firm size suggest that the pandemic disproportionally impacted small firms.13 This observation, however, is not yet visible in many of the business sector statistics Bank staff monitor regularly.

Conclusion

The analysis presented in this note shows preliminary evidence on the impact of the pandemic on Canadian businesses. Overall, the extraordinary support programs launched by governments and the Bank appear to have successfully mitigated the impact on the financial health of businesses. That said, we know this picture masks different realities for different types of firms, and that many small businesses are struggling. Large firms are more likely to directly cause systemic problems for the financial system if they default on their debts. From an economic and human perspective, however, small and medium-sized enterprises are important contributors to employment and Canada’s prosperity. At this stage, we cannot conclude with certainty that the financial health of the business sector has been or will remain unscathed by the pandemic. The pandemic could leave some businesses, especially those in hard-hit industries, in a financially vulnerable position, notably due to high levels of debt. There is also a risk of a large and sudden increase in insolvencies among businesses as government programs run their course.

Bank staff will continue to track the financial health of businesses as more data are released. The Bank will report notable developments on its Financial System Hub and in the Financial System Review.

Appendix: Details of the microsimulation model

Table A-1 provides a breakdown of how the various components are assumed to evolve through time.

Table A-1: Assumptions

Variable Assumptions
Revenue growth Determined by gross domestic product forecasts consistent with the January 2021 Monetary Policy Report
Expense elasticities to revenue Matches 2019 firm dynamics
Working capital Grows at same rate as revenue
Investment Enough invested to maintain productive capacity
Dividends Paid if cash is available

Figure A-1 shows how cash buffers evolve from one quarter to the next.

Figure A-1: Cash flow dynamics in the model

Figure A-1: Cash flow dynamics in the model

  1. 1. See the Statistics Canada website for more details on its Canadian Survey on Business Conditions.[]
  2. 2. The Government of Canada provides statistics on program use: CEBA, CEWS and CERS. Information on the full suite of government support programs for businesses is available in Canada’s COVID‑19 Economic Response Plan.[]
  3. 3. For more information on the measures the Bank has taken during the pandemic, see COVID‑19: Actions to Support the Economy and Financial System.[]
  4. 4. For the latest data on business lending conditions, see the SLOS.[]
  5. 5. Data from the Compustat database were used for this analysis.[]
  6. 6. Large firms can file for debt renegotiation through the Companies Creditors’ Arrangement Act. These filings reached an all-time high in the second quarter of 2020 but were low in absolute terms and have since fallen to typical levels observed over the last 10 years. Also, instead of filing for bankruptcy, firms can exit in other ways. These include through mergers and acquisitions and by simply winding down their business and paying off any outstanding debt.[]
  7. 7. For a discussion of distance to default applied to Canadian financial institutions, see MacDonald, Van Oordt and Scott (2016). Formal details of the Merton Model can be found in Merton (1974).[]
  8. 8. Grieder and Schaffter (2019) point to considerable unevenness in vulnerability patterns across firms. They also highlight that the share of overall debt that vulnerable firms owed was at an all-time high due to developments in industries that are sensitive to commodity prices.[]
  9. 9. Debt overhang occurs when a firm’s existing debt levels discourage its shareholders or new creditors from financing profitable investments. This distortion arises because some of the payoff benefits existing creditors rather than benefiting only those who financed the new investment. For recent examples of how debt overhang can lead to sluggish recoveries, see Bustamante (2020) and Blickle and Santos (2020).[]
  10. 10. Details of the model are found in the Appendix. Although our simulations are consistent with forecasts of gross domestic product presented in the January 2021 Monetary Policy Report, considerable uncertainty surrounds cash flow projections for firms in the hardest-hit sectors.[]
  11. 11. In reality, firms will choose their optimal liquidity and capital structure to fit their individual circumstances (Gryglewicz 2011). Thus, our simulation exercise should be viewed as an approximation rather than a precise calculation.[]
  12. 12. We use the two definitions of zombie firms proposed by Banerjee and Hoffmann (2018). The broad definition identifies a firm as a zombie if it is old and has been persistently unable to generate enough income to make its interest payments. The narrow definition has the additional requirement that a firm’s profitability is expected to remain weak in the future. See Grieder and Ortega (2020) for a discussion of the prevalence of zombie firms and their potential impact on the financial system before the onset of the pandemic.[]
  13. 13. See “Study: Economic Impact of the COVID‑19 Pandemic on Canadian Businesses Across Firm Size Classes,” Statistics Canada, August 19, 2020.[]

References

  1. Banerjee, R. and B. Hofmann. 2018. “The Rise of Zombie Firms: Causes and Consequences.” BIS Quarterly Review, September: 67–78.
  2. Bustamante, C. 2020. “Debt Overhang, Monetary Policy, and Economic Recoveries After Large Recessions.” Mimeo. Bank of Canada.
  3. Blickle, K. S. and J. A. C. Santos. 2020. “The Costs of Corporate Debt Overhang Following the COVID‑19 Outbreak.” Liberty Street Economics. Federal Reserve Bank of New York, December 1.
  4. Davydenko, S. A. 2013. “Insolvency, Illiquidity, and the Risk of Default.” Mimeo. Joseph L. Rotman School of Management, University of Toronto, February.
  5. Fortier-Labonté, A. 2021. “The Impact of the Pandemic on the Solvency of Corporations, Third Quarter 2020.” Statistics Canada, January 18.
  6. Grieder, T. and J. Ortega. 2020. “A Financial Stability Analysis of Zombie Firms in Canada.” Bank of Canada Staff Analytical Note No. 2020-3.
  7. Grieder, T. and C. Schaffter. 2019. “Measuring Non-Financial Corporate Sector Vulnerabilities in Canada.” Bank of Canada Staff Analytical Note No. 2019-15.
  8. Gryglewicz, S. 2011. “A Theory of Corporate Financial Decisions with Liquidity and Solvency Concerns.” Journal of Financial Economics 99 (2): 365–384.
  9. MacDonald, C., M. van Oordt and R. Scott. 2016. “Implementing Market-Based Indicators to Monitor Vulnerabilities of Financial Institutions.” Bank of Canada Staff Analytical Note No. 2016-5.
  10. Merton, R. C. 1974. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance 29 (2): 449–470.
  11. Myers, S. C. 1977. “Determinants of Corporate Borrowing.” Journal of Financial Economics 5 (2): 147–175.

Disclaimer

Bank of Canada staff analytical notes are short articles that focus on topical issues relevant to the current economic and financial context, produced independently from the Bank’s Governing Council. This work may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this note are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.