Getting the bounce back into the economy
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The business distress index: a tale of three economies
Rolf Hickmann, Managing Director, pH, an Experian company
A tale of three economies is emerging as the UK progresses through the recession. But, it may not be the story many expect. A quarter on from our last report, we are still not observing recession-level insolvencies − in fact, all the metrics for April are positive. Digging deeper, analysis shows that while smaller businesses are still holding up despite the recession, the impact is visible on mid-sized and larger organisations, particularly in terms of the insolvency rate.
Each recession has its own anatomy and internal logic. This one is characterised, and was indeed triggered, by the balance sheet and liquidity calamity within the banking sector. A calamity of such epic proportions that it was a front-page news fixture for months, exerting huge psychological impact on the public at large, causing sudden and significant deferral of large purchase decisions (and large deflation of values) on big ticket items and assets such as cars and homes.
The knock-on effect for these industries, typically populated by few employers but each with very significant employment, has been devastating, and they have had to take an axe to their cost structures to adjust to the drop in demand, making staff redundant - further reinforcing, of course, the doom loop and affecting demand. As a result, GDP is sharply down, unemployment is sharply up and the economy is in trouble.
All that is needed to make the picture of gloom complete is to confirm the demise of the ‘third estate’ in the economy; the broad population of small and medium-sized firms across the remaining industry sectors. Over 90% of all UK companies fall in the SME category and are especially prevalent in the services and retail sectors.
Indeed, the demise of the SME economy, as opposed to that of the banking, automotive and housing sectors, has also been a constant and intoxicating message in the media these past months. This has been helping to drive a second stage of this recession, the psychological engine which has followed the original fallout in the financial sector.
- the evidence shown here confirms, against all expectations, that the SME population at large still continues to remain resilient in spite of all this adversity
- even as operating results within the ‘real’ UK banking sector, i.e. its recurrent, operational P&L results (away from US toxic securitised assets, from misjudged mega-mergers, and from over-reliance on funding from the wholesale markets) prove on the whole to be respectable
So is there some hope for a short-and-sharp, rather than long-and-deep, recession? And could the psychology be reversed? Or are we heading for a final cycle of calamity?
What’s happening now?: the real evidence on SMEs
Using data collected via Companies House, pH has been closely tracking insolvencies across the business population, and the progress of the recession since September 2008.
And still, the spike in overall company insolvency rates (business failures as a percentage of the business base), observed in the 1991 recession has not appeared.
In fact, after a measured (but far from catastrophic) rise since the final quarter of 2007, the overall insolvency rate was actually down in January 2009 from its level in December 2008, and after coming back up for two months at the end of March, is actually down again in April. It still lies at only a third of its 1991 level!
While the sheer numbers of defaults have visibly risen faster since mid-2007, so has the base of live firms, which is largely overlooked. Critically, this oversight invalidates the message that we are at record insolvency levels. In fact, we are still far from the 1991 peak in terms of default rate (the correct measure) and just barely back up to…early 2003 levels! Indeed, April’s figure was down (see raw volumes chart below).
Stepping back for a broader perspective and looking at the financial solidity of the UK business population, it is evident that the average balance sheet strength has improved from February and into April 2009. This is the case across all UK regions, which again is coherent with the other analyses. The pH Megascore is a default probability model, which takes balance-sheet and P&L factors into account, such as liquidity and gearing, to generate a score of between one and 100 that measures the financial solidity of the business population. This measure reflects balance sheets filed in many cases before the onset of this recession, however many already do reflect it, and in any case the score has been validated as a very strong predictor of future business failures. What this score also points to is that the average level of financial health prevalent within the business population was quite good before the unexpected onset of the liquidity crisis. It would have been far worse had the tsunami hit at a time when the foundations were weaker.
Drawing on Experian’s commercial database of UK payment information, which tracks 20 million transactions worth £15billion each month to indicate good and poor invoice payment trends, provides an invaluable insight into the impact of the recession in terms of liquidity.
Not only has the average number of days beyond terms (DBT) practised by firms in their payments not exploded since the crisis, it has actually remained quite stable and at a relatively benign level up to March and even started to decline in April 2009, standing at 23 days. This confirms the insolvency rate and Megascore message: no catastrophic transition is yet visible overall. Instead, there has been a broad-based and consistent short term improvement.
There are, of course, marked differences between the key industry sectors. Since the start of 2008, the property sector has seen its DBT increase by almost 12 days, from 28 days to 40 days. Finance and business services are two additional slow paying sectors. The finance sector’s DBT has increased from a recent low of 18 days in January 2008 to 27 days at the end of April 2009. Business services, meanwhile, is the third slowest paying sector with a current DBT of 25 days.
Analysing payment performance by size of business clearly shows that the very largest businesses (1,000 plus employees) are paying their bills considerably more slowly than smaller businesses – 45 days beyond terms at the end of April 2009, compared to the next slowest payer (251-1,000 employees) at 31 days beyond terms.
Businesses with 50 employees or fewer are the promptest payers; organisations with 11 to 25 employees pay bills 20 days beyond terms on average.
In fact, focusing further on company size, a much more striking feature of the trend in company insolvencies is revealed. It is a tale of three economies: the small, the mid-range, and the large – with very differentiated and counterintuitive insolvency patterns.
The smallest businesses (0-1, 2-5, and 6-10 employee firms) have actually been experiencing the lowest default rates, and seem least affected by the current crisis. Mid-range businesses (11-25, 26-50 and 51-100 employee firms) have consistently been experiencing the highest default rates, moreover with significant uplift since mid-2008 and in recession since then. Finally, the largest (100-500 and 501+ employees) have evolved from having the lowest default rates at the start of the century, to an intermediary (and crisissensitive) position as at the end of March 2009.
This suggests it is the mid and upper mid-market which policy makers should be focusing their efforts on. However, all five bands actually improve − the mid and large size by a considerable amount − in April.
How will the business landscape look post-recession?
So where will we finally land? And what will the business landscape look like when we do? The challenge is working out exactly where we are now. Coming back to the insolvency rate, there is an apparent lag of a few quarters between a significant drop in GDP and subsequent mass insolvencies, and of course GDP has just suffered a massive drop. So is there still a major leg of this recession to come, with a real jump in SME insolvencies? Or, is this not instead evidence that the SME population, the backbone of the economy, is not yet in a terminal state?
Imagine the consequences of letting this runaway train run its course: SME default rates would finally lift up, they could even reach their 1991 peaks, meaning that a spate of default rates three times higher than the current ones will be experienced - but on a much larger base of firms than in 1991 – and even if we assume just a few job losses per firm on average, with a 1992-like rate of insolvencies persisting over several quarters, we would be facing a large incremental rise in unemployed from the SME sector alone.
What we will see when we start the upturn is that weaker firms will be fewer on the ground. Notwithstanding the relatively low insolvency rate we are experiencing, the weakest firms will not survive, leaving the business base overall financially stronger by measures such as the Megascore, our probability model that measures the financial strength of a business and its likelihood of failure due to financial distress.
Insolvencies in raw volume terms are likely to flatten again at what has up until 2007 been a baseline of around 1,500 per month, but still against a growing business population. Despite the recession, there were over 91,000 new business registrations in the first three months of 2009, down slightly on the 2008 level, but still outweighing the number of business failures significantly. Once confidence returns, both the number of new business registrations and the business birth rate (the number of new businesses as a percentage of the base) would be expected to increase – although given the slow recovery anticipated, at a somewhat slower rate than after previous recessions. After the recession of the 1990’s the number of new businesses registered grew from a little under 116,000 in 1993 to almost 406,000 ten years later, while over the same period the business birth rate increased from 10% to 19%.
What we do know is that the SME economy has shown itself to be remarkably resilient so far and all the evidence shows there is still time to avert the worst.