The balance sheet of British business has passed through a truly remarkable transformation over the past two years. Statistics and anecdotal evidence in every sector and at every level, from giant household names down to modest seven-figure enterprises, all confirm the pattern: gearing levels radically reduced, businesses managing their cash-flow more intelligently than ever before, and deep-seated reluctance to borrow afresh.
In many respects, this is a positive story. Companies are emerging from the recession in impressive shape, having learned the lessons of sound financial management through bitter experience. But it raises three interesting questions. First, will the caution now being displayed by many British companies cause them to miss investment opportunities and allow foreign competitors to reap the benef its of economic recovery? Second, what will the banks - now rediscovering their enthusiasm for corporate lending - do with their money? And third, should analysts tear up traditional balance-sheet ratios and find new ways of assessing relative corporate creditworthiness?
The big picture is provided by Bank of England statistics which show that industrial and commercial compa-nies have been repaying debt steadily since the beginning of 1993. The net reduction for the seven quarters up to September 1994 was £7 billion. New financing was provided instead by a combination of capital issues (£16 billion) and retained earnings, which rose by 3% in 1993 and began 1994 at double the level of the worst period of recession. Helped by lower nominal interest rates since the pound fell out of the ERM, interest costs fell by more than a third between 1990 and 1994. The crucial ratio of income gearing (interest costs to net profits) across the corporate spectrum has halved, from over 30% to about 15% today. Ratios of debt to equity, which is important for large companies seeking to maintain formal credit ratings or comply with syndicated loan covenants, have improved by 30-40% since the peak of the lending extravaganza. A survey by accountants KPMG of 133 quoted companies in the West Midlands (see table, p58) shows the average debt/equity ratio falling between 1992/3 and 1993/94 from 32% to 23%. Within those figures, the biggest percentage reduction in gearing (37%) was in companies with market capitalisations of £100 million-plus. These quantum changes in gearing levels have been achieved despite a policy shift which has had the opposite effect on some big company balance sheets: this was the decision by the Accounting Standards Board to take a tougher line on the classification of impermanent hybrid securities as debt rather than equity. Clever City inventions such as the auction market preferred share and the convertible capital bond were re-bracketed as liabilities, affecting a variety of major companies from British Airways to Reckitt & Colman. Creative accounting is now very much yesterday's game.
Attitudes of straightforward prudence now apply both to capital investment and to working capital financing. In both respects, the quelling of inflation to al most negligible levels of 1-2% per annum is a new factor. Without inflation, real costs of borrowing and rates of return are theoretically plainer to compare. Economists argue that serious long-term investment is thereby encouraged, but many smaller businessmen are deterred by the rigorous nature of the calculation involved: in crude terms investment was easier in the old days because term debt was easier to repay as inflation acted to diminish it, while boosting the residual value of the asset financed.
Absence of inflation in working capital requirements also reduces demand for overdraft financing. But more importantly, so also do the structural changes which have taken place, as a result of the recession, in the way businesses manage their cash flow. According to Kevin Jennings, director of commercial marketing at National Westminster Bank, there has been a `major shift in business literacy', in which managers have learned to run higher levels of turnover on lower levels of short-term finance by much more rigorous attention to stocks, debtors and creditors. Technology has helped, both in computerised stock control and in the use of electronic cash management products offered by the banks.
The new techniques have sometimes tended to favour big companies over small ones. Powerful manufacturers and retail groups have learned to extract longer credit terms from smaller suppliers who depend on them for orders. At the most sophisticated level, just-in-time component and stock delivery has tended to shift the financing requirement down the chain of suppliers, forcing each participant to re-examine his modus operandi. One entrepreneur who has felt this squeeze is Quinton Cornforth, who runs Bodybits, a chain of discount body-panel stores in the Midlands: `Yes, we're much better at managing our stock and our cash flow than we used to be and we've reduced our borrowings enormously. But our exposure to debtors has gone up by about 30% because all our big customers are asking for longer credit terms. In some ways, the trend has gone too far: maybe we're all spending too many hours checking 58e stock controls and chasing debtors to keep our overdrafts to a minimum.'
But most post-recession entrepreneurs agree that it is well worth the headaches to keep borrowing to a minimum. Reflex Magnetics is a successful computer software maker and furniture importer in Kilburn, north west London. Its managing director, John Buckle, says: `I've always tried to keep my bank debt well under control and I've never had any grief from them. Gearing ratios as such don't really concern me at all, but I'm constantly watching three figures which give me an overview of the net trading position: the overdraft, what I owe my suppliers and what my customers owe me. If the pattern looks positive then I'm prepared to look at new investment.'
After a faltering start to the recovery, new capital investment is at last a live possibility again for many British companies. Jennings of NatWest has observed a real improvement in confidence, particularly among medium-sized businesses in the manufacturing sector, since April 1994. Bruce Robinson, executive director of Arbuthnot Latham, confirms the picture: `Investment in capital goods is certainly picking up, often driven by advances in technology rather than market expansion. Companies which haven't invested seriously for three or four years - in the printing industry, for instance - have fallen behind the game. They've survived this far, but they've got to start investing in new-generation equipment if they want to be really competitive.'
In the new mood of realism, borrowing demand is likely to be seen first in the safest sectors, where entrepreneurs are able to believe in their own business plans, rather than in the more speculative sectors. The 1980s view that any business should gear up for expansion if it has room in its balance sheet now counts as a flat-earth theory of corporate finance. Similarly, the standard sectoral gearing ratios which credit analysts looked for in earlier business cycles are for the time being much less useful bench-marks: all well-run businesses, what ever their sector, are now finding ways of running themselves on lower levels of debt, but those which are leading the recovery are likely to gear up ahead of those which are traditionally heavier borrowers. Credit analysts will have to re-write their own rules, concentrating less on the bald figures of the balance sheet and more on the realities of cash flow and the persuasiveness of future business plans.
There is, of course, another side to the story. Demand for borrowing may be under control, but what of supply? In the last boom it was undeniably true that banks poured fuel onto the flames by their very aggressive lending policies, driven by the need to fill their own balance sheets in order to show an adequate re turn on capital. More recently, the talk has been of a `flight to quality' and as Martin Taylor of Barclays told Management Today (November 1994) a willingness to shrink the lending business in order to stay within acceptable parameters of risk.
But the willingness of the wider corporate lending market to take such a radically sensible view is called into question by a new survey by the Bank Relationship Consultancy (BRC). Of the 139 banks polled, 68% expected to be growing their loan books in a year's time: of those, three-quarters foresaw a growth rate of more than 5 % and 17 of them were looking for growth of more than 15%. The survey of corporate borrowing intentions makes these ambitions look wildly unrealistic: one third of companies were planning to increase their bank debt next year, but another quarter were still planning to reduce it.
Even worse news for the lenders is that many companies will meet their new funding requirements from sources other than banks - the buzz word is `disintermediation'. In the BRC survey, bank debt emerges as a low choice, behind private placements, leasing and bonds, with many of the largest companies planning to switch out of bank debt to the advantage of these other markets. A vivid example of this trend is Guinness, which reduced bank borrowings as a proportion of total debt from 91% in 1987 to 15% in 1993. The NatWest's latest quarterly survey of companies with less than £130 million turnover also finds many of them expecting to borrow from non-bank sources, or use more trade credit, or seek access to venture capital, as alternatives to borrowing from their banks.
This yawning discrepancy between demand and supply can only lead in one direction: towards a cutting of margins, a relaxation of gearing and other covenants and a quiet bending of quality parameters on the part of bankers. The favoured recipients of the banks' marketing attentions, according to the BRC, will be the food, utilities, chemicals, machinery and retail sectors. Anything property or leisure-related (or connected with the public sector - NHS trusts and local authorities, for example) will continue to be left out in the cold. But perhaps not for long, as the credit cycle begins to gather fresh momentum.
`The speed of change in the bank's attitudes has really surprised us this year,' says Michael Bryant, deputy treasurer of GKN. `It's the exact reverse of the situation just a few years ago, when companies needed the money and the banks were walking away. Now we're liquid, and they're beginning to fall over themselves to lend again. We're almost as selective in who we're prepared to borrow from as they used to be in assessing us.' One smaller factory owner puts it even more succinctly: `I may have tended to err on the side of safety, but I'm bloody glad that I did. Experience says that the one time you shouldn't be gearing up is when the bank starts telling you it's a good idea.'
Equity gearing ratios by company size*
Total % Total %
(market cap. above £100m) 22.4 35.7
Medium (£50m-£100m) 23.4 29.3
Small (under £50m) 35.1 43.3
Equity gearing ratios by sector*
Construction and property 30.8 45.4
Motor and distributors 22.0 32.0
Food and drink 23.8 28.9
Engineering 42.3 43.9
Retailing - 2.5
Utilities 14.2 19.0
Industrial materials 28.9 37.8
Electricals 20.2 22.3
Electronics - 2.4
Other 38.5 72.5
Average 23.4 32.0
*For selected West Midland companies
Equity gearing ratio = Total borrowings net of cash
---------------------------- Share capital plus reserves (exc. minority interests)
Source: KPMG West Midlands plc annual report 1994. Martin Vander Weyer is an associate editor of The Spectator.