Could perception be helping to drive down the economy?

How much have businesses in the UK been affected by the current liquidity crisis? And when exactly did the downturn start to impact on small businesses? While there have been numerous media reports and debates around these questions in recent months, a glut of very high profile retailing insolvencies and job losses, much of the evidence relating to small and medium sized enterprises (SMEs), in particular, has been heavily anecdotal.

Our contention is that, although there has clearly been damage to the economy, the situation is far from terminal and the SME population can be protected from a recession if we act quickly enough.

It is true that the raw insolvency data shows the number of insolvencies in the UK has been rising since CY07, after 10 years of stability. Certainly, the insolvency figures make good headlines. Overall in Q4 CY08 more than 7,000 businesses failed, an increase of 53% compared to Q4 CY07. The retail failures of well-known high street names are dominating the business pages, but in reality it’s the business services and building and construction sectors that have experienced the highest failure levels. Over 1,600 companies in the business services sector and over 700 in building and construction failed in the final quarter of the year, increases of 49% and 44% respectively on the situation in Q4 CY07.(4)

 

 

It is important to recognise that raw insolvency data does present a good overall measure of what’s happening in the economy. What we need to be mindful of, however, is that as well as an increase in failures, the underlying business population has also been rising in recent years.

To determine the extent to which the economy really is suffering, we need to consider insolvencies as a percentage of the overall business base to give an insolvency rate. This reveals a somewhat different picture.

Our analysis of the financial and insolvency data of every business registered at Companies House5, suggests that early reports of significant damage to the SME economy at the end of Q3 CY09 brought about by the developing recession were exaggerated: the business-to-business population in the UK had not yet suffered significant insolvency rates from the credit crunch as of September 20086, despite the fallout in the financial sector. The first real evidence of distress, as measured by insolvency rates, only appeared at the beginning of Q4 CY08, although even as of the end of December 2008, this was still far from reaching recession levels. In fact, the current insolvency rate is only back up to the levels of 2004, a very benign year.

 

 

Going back to 1990 and tracking the insolvency rate forward to Q4 CY08 shows that the default rate has actually been steadily improving all the way from 1992 until Q3 CY08. Only with Q4 CY08 did an increasing trend line become apparent from mid- 2007, although even at the end of the quarter, the real rate of insolvencies amongst the B2B population was less than half that experienced during the recession of the early Nineties. As the chart comparing GDP and raw insolvencies highlights, there is a lag of between two and three quarters between a shrinkage in Gross Domestic Product (GDP) and a corresponding increase in insolvencies. This suggests that the insolvency rate could jump over the next six months, which does gives a window of opportunity to take action. So, this leaves six months for intelligent new policies to prevent a huge increase in default rates reaching back to 1991 levels.

 

 

The real insolvency rate is one measure, but this general trend in Q4 CY08 is confirmed by looking at other measures, such as the financial solidity of SMEs. This can be gained by looking at the pH Megascore, a default probability model. The Megascore 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 and it is validated as a strong predictor of default rates 12 to 24 months out.

Looking at the average Megascore by key industry sector from 2006, it’s clear that there has only been on average a very gentle decline in the financial strength of the business population since late 2006. But this decline is well within normal historical variations, even in Q4 CY08 and remains at around 80 out of 100.

 

 

The speed at which businesses are paying their bills provides a good indicator of liquidity. Such analysis is gained by collecting millions of invoices across the economy, and calculating, every month based on last month’s captured invoices, the average days beyond terms (DBT) which characterise each firm covered by the data during that month. Looking at this measure it’s evident that, much like the Megascore measure of financial strength, the DBT has been rising but only very gradually, since the end of 2007, from just under 20 days to 23 days in December – and with no spike at all.

 

 

Similar to the consumer environment, it seems that perception has played a part in driving reality in the business sector.

Despite the fact that there were clearly a great deal of healthy and financially stable SMEs in the economy as at Q4 CY08, the rate of business formations points to problems ahead. The business birth rate is a good immediate and flashing indicator of a developing recession, reflecting both economic confidence and factors such as access to funding and development capital.

Our analysis of business births, gained by monitoring all firms that register at Companies House, shows a decline in company formations in 2008 back to 2004 levels. In 2008 just over 350,000 new businesses were formed, in contrast to over 450,000 registrations in 2007, and the lowest figure since 2004 when just under 350,000 new businesses were established.

It comes as little surprise then that fewer companies have been getting together and that deal volumes and values are down for 2008. According to information on deal activity from the Worldwide Deals database from Corpfin®7 overall in 2008 a total of 5,251 transactions were announced, which represents a 21.5% decrease on the figure from 2007 with 6,691 deals. Deal values have declined by a greater magnitude with year end analysis showing that 2008 saw a total of £207.4billion transactions, a 54% decrease in comparison with 2007’s figure of £450.5billion.

 

 

The final quarter of the year is traditionally a slow quarter in corporate finance. Although there was a decline compared to Q3 CY08, deal activity has not stopped altogether. Across the UK there was an 18.5% decline in the number of deals announced during Q4 CY08 compared to Q3 CY08. Still, 892 deals were announced. Deal values in Q4 CY08 declined to £30.4billion, a decrease of 48.1% on the Q3 CY08 figure of £58.7billion.

 

 

What the company birth rate clearly shows is that those who may have previously been considering starting up a new business are either deciding to postpone and remain in their current employment or are finding it too difficult to obtain funding for their new venture.

If little action is taken to address this issue then we would expect the company birth rate to slow further in 2009. Of course, our statistics shows that 40% of new businesses formations never trade or file accounts, but simply dissolve within two years of being established. Nevertheless, new business formations are essential to maintain a vibrant and buoyant economy, creating the mediumsized and big businesses of the future.

Meanwhile, for three months in a row business failures have hovered around the 2,500 mark. On a very benign trend and from a very low death rate, this is in itself not catastrophic – again, provided businesses can still get access to credit. Without this, over the course of 2009 the death rate could double and we could start to see insolvencies increase to an average level of 5,000 per month.

Deal activity is slowing, but it has not stopped. What is happening is that deal financials are being re-worked many times with offers trimmed and renegotiations started. It doesn’t take much of a disagreement, even in normal circumstances, to de-rail a deal.

In the deals market, the new reality is that the level of activity seen in Q4 CY08 should be considered as a comparator for Q1 CY09 performance. The final quarter of 2008 should be the baseline against which we measure deal activity going forward.

Both the insolvency rate and the Megascore have a built-in time lag. The death rate is an unassailable measure, but can only flash when there are no longer vital signs for a given business, it cannot provide prior warning of distress. The Megascore is based on filed accounts, and thus represents a firm’s solidity as of several months ago. Nonetheless it is an excellent predictor of default, because it captures the ability of a firm, with a given set of past, but recent financials, to weather new negative external stimuli, such as a world-wide liquidity crunch, or a sudden reluctance of high street banks to continue to extend credit. Payment performance is a good non-lagged measure of how businesses are faring.

Taken together, what our data insight shows is that the SME population was on the whole holding up well until September 2008. In Q4 CY08 there was a decline, but businesses are still not exhibiting catastrophic financial behaviours.

Looking at the relationship between Gross Domestic Product (GDP) and insolvencies, and with the news that the economy shrank in Q4 CY08, there is clearly still time in 2009 to prevent a substantial increase in business deaths and avert a deep or long recession insofar as the SME population is concerned.

However, for this to be the case two things need to happen. Firstly, banks must have the confidence to start lending again. An average Megascore of 80 is a very positive score showing that there are many healthy businesses around. Secondly, large businesses must get quicker at paying their bills. These businesses are the slowest payers and speeding up payment to medium and small business will be pivotal in solving the problem.

What is clear is that the business environment is changing rapidly, putting new demands on organisations in terms of the level of insight and business information they need. Relying on sparse financial information to make business-critical decisions under these conditions could spell disaster. Deal appetite may wane over coming months. But, in challenging times identifying credible potential acquisition targets or buyers is even more crucial, as is pinpointing the advisors that other professional firms and businesses should be getting close to.

Real-time, up-to-date business information is essential to allow organisations to know the true financial position of their customers’ businesses and business owners on a daily basis. Vigilance is the watchword. That means using information that can give an early warning of a business heading for difficulties, such as a major reduction in share capital, late filing of accounts and adverse notices, such as County Court Judgements.

Payment performance data should be used to identify customers’ payment patterns and worsening payment trends – a strong indicator of reduced cashflow leading to possible insolvency. This insight will not only give a view of if a customer is likely to pay, but also when – crucial information in times of tight liquidity.

The outlook for Q1 CY09 does not look any better than recent performance, with the economy set to contract by at least another 1%. All components of demand are set to shrink, except for government spending. With another 200,000 jobs to be lost in Q1 CY09, consumer spending will contract for the fourth consecutive quarter, by 0.8%. Investment activity will decline by close to 2%.

Some analysts are calling Q1 CY09 the trough in the downturn. While it is true that the worst declines might be behind us, economic activity will not hit bottom until Q3 CY09, with discernible growth postponed until CY2010. This presents one of the main risks: lofty expectations potentially resulting in further sell-offs on financial markets, with implications for sterling and UK asset prices.

 

 

In terms of the business environment, the business birth rate is falling and without an improvement in the availability of business finance and an improvement in confidence it will slow further. Insolvencies are rising and helping to fuel the feeling of doom and gloom about the economy.

But it is important not to lose sight of the positives. With government infrastructure plans being brought forward, it is possible that the recovery in construction will lead the overall economy by a quarter or two. Inflation will no longer be a concern, particularly with prices for energy and later food falling significantly.

Meanwhile, the insolvency rate is still some considerable way off the levels experienced in the last recession (taking into account the increased business population). Indicators show that there are still a great many healthy businesses in the SME population in particular and if they can keep their credit lines open and cashflow positive, they may be able to avoid the worst of any recession. In this respect, the news of more job losses can be misleading; businesses are remaining healthy precisely because they are taking measures to manage their costs, including reducing employment costs.

1. Anticipate and prevent exposure to losses by using data insight

Businesses of all sizes need to be taking action to minimise the threat of the downturn to their business. That means accessing real time, up-to-the minute business information and using this in two ways. Firstly, as the basis for choosing new customers and monitoring existing customers for early signs of distress and secondly, for ensuring that their business maintains a low risk profile and remains in good shape to keep credit lines open.

2. Payment performance data – a critical tool

Within this business landscape, payment performance behaviour is one of the most insightful pieces of information a business can have. A worsening payment trend is one of the clearest signs of a business experiencing difficulties. Rather than relying solely on traditional profit and loss or balance sheet data, payment performance information can give an early warning of a business heading for trouble.

Companies that really understand these payment dynamics at an individual client level are the ones that stand a better chance of surviving the economic challenges of the next few years. Being able to customise credit collection strategies will be a source of significant competitive – and survival – advantage. Cash flow is king.

4. Note that the 'raw' data has twice been polluted in recent years by abnormal default events (i.e. in October 2006 and 2008, see the green line peaks on the raw insolvency data chart), when some 700 insolvencies all occur on the same date at the same address, above the trend line of 1,500 to 2,000 per month. These turn out to be associated to one umberella organisation each time, so the time series is adjusted accordingly

5. Excluding firms that are registered at Companies House but do not trade. Excludes Partnerships and Sole Traders as these are not registered at Companies House. Excluding firms less than 24 months old

6. 97 per cent of UK firms employ less than 20 people. Source: Federation of Small Businesses

7. Corpfin deal analysis covers the following types of deal: Acquisition, Acquisition – tender offer, Development Capital, Divestment, Employee Buy-In, Employee Buy-Out, Exit, Partial Exit, Flotation, Investor Buy-In, Investor Buy-Out, Tender Offer, Leveraged Buy-Out, Management Buy-In, Management Buy-In/Buy-Out, Management Buy-Out, Merger, Minority Stake, Minority Stake – tender offer, Reverse Takeover, Secondary Buy-Out or Share Buy-back.

Data includes transactions with deal value of £500,000+, property deals must be over £15 million. Stakes in oil and gas fields and bond issues are not covered.

Pending deals included, completed deals included, cancelled deals excluded, rumoured deals excluded.