Rate of Distressed businesses falls in 2010, with sector-specific risks in medium term

The financial health of UK businesses is improving but there are significant risks in the medium term, say two respected accountancy firms.

Begbies Traynor and Deloitte, have both released surveys on the levels of businesses in distress. The following is a report and analysis of their findings.

Begbies Traynor's Red Flag alert has shown that the number of companies experiencing financial distress has fallen by 21 per cent, whilst Deloitte has pointed out that the number of administrations in the last six months has fallen by 43 per cent compared to the same period last year.

Deloitte appears to be more upbeat than Begbies Traynor but they monitor actual formal insolvency situations whereas Begbies Traynor monitor a range of indicators such as outstanding county court judgements and late filing of accounts.

Begbies Traynor's recent Red Flag statistics for the second quarter of 2010, show that the 127,000 companies experiencing distress in the period was a marked fall of 21 per cent from the 161,601 registered for quarter one, and was 31 per cent down on the peak levels of 185,813 from quarter two 2009.

Ric Traynor, the executive chairman of the group, said it appears the post-recession stress is migrating away from the small to medium-sized businesses and beginning to take effect in larger companies. This, he warned, proves ominous for the threat of greater job losses and serves to emphasise the fragility of the UK's economic recovery.

"We believe that a combination of lenient creditor attitudes and temporary government support measures - including the extensive use of monetary instruments, such as quantitative easing and low interest rates - have all had an effect on reducing the volume of adverse actions, providing a welcome respite to many companies that may have otherwise found it difficult to survive," he said.

"We are concerned, however, that the levels of business distress will increase again, potentially for the first half of 2011, once the effects of the coalition government's fiscal tightening measures impact the economy and particularly among those private sector businesses most dependent on public sector contracts."

In past recessions, the level of insolvencies continued to grow strongly for two to four years after the GDP stopped shrinking. However this time, companies have learnt to be flexible and adaptable, with employees being willing to work fewer hours or taking a small pay cut.

However, with regard to actual insolvency situations, Lee Manning from Deloitte said, "The summer months traditionally see lower levels of administration activity, particularly given the periodic absence of key decision makers taking summers holidays.

"We expect this decline to continue into Quarter Three. Confidence has been on the rise, with consumer spending holding up better than expected, and corporate confidence being felt more widely. For example manufacturing, one sub-sector impacted, has experienced improved output," he said.

While the numbers of businesses experiencing 'significant' or 'critical' financial distress dropped from the figure for quarter one, their cumulative debt significantly jumped by 26 per cent - from £55 billion to £69.5 billion. In terms of average debt per company, this represented a 60 per cent increase from £340,000 in quarter one to approximately £545,000 in the second quarter. This figure, Begbies Traynor reported, betrayed the increasing average size of the businesses facing trouble.

The growing debt levels followed the rise in corporate credit availability reported in the Bank of England's credit conditions survey. The increasing availability was, however, not as strong as many had expected it to be: just 7.1 per cent of the lenders actually reported an increase; nowhere near the 22 per cent who had previously indicated that they were expecting one.

This failure to meet expectations is further reflected in the diminishing outlook going forward. For the third quarter of 2010, availability is predicted to reach its lowest level since the end of 2008, with the balance of lenders expecting an increase falling to just 6.5 per cent. In comparison, the levels for the previous five quarters to quarter one of 2010 were between 20.5 and 28.9 per cent.

More stringent scrutiny by HM Revenue and Customs (HMRC) of applications to its business support scheme will also likely lead, Traynor said, to more difficult conditions for those seeking corporate credit.

"HMRC's increased scrutiny for applications to its time to pay scheme, provide early indications that it is taking a more selective stance towards businesses over their outstanding liabilities with a focus on helping businesses that have a genuine chance of survival," he said.

The report confirmed fears by many people in the construction, business services, IT, advertising and recruitment industries that they are in line to be most harshly hit by the government's austerity measures in the coming months. Businesses experiencing difficulties in these sectors alone topped 52,000 in the second quarter of 2010 - and that was before feeling any sort of effect from the government cutbacks.

The construction and IT sectors in particular have shown to be struggling to establish similar rates of recovery as other sectors in quarter two 2010. They have grown year-on-year by just 17 and 16 per cent respectively - fractions of the average improvement rate of 31 per cent.

Traynor said in the event that the country does not enter a 'double-dip' recession, there remains the risk of a dual speed recovery, with the comprehensive spending review, due in October, likely to be a watershed moment for construction and IT contractors.

"There's a growing risk that, even if the UK avoids a double-dip recession, it could develop a twin track economy," Traynor explained. "Public sector-dependent industries could be facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."

The better-off sectors are expected to be manufacturing and retail, which have experienced the strongest improvements in the numbers of businesses facing overwhelming problems. Manufacturing saw a 37 per cent drop in distressed companies, with retail registering a 38 per cent fall, both gathering steam on the back of improved export and consumer demand.

However, it should be noted that these industries were particularly hard hit in the 2008/20009 fiscal year and the ones left are strong. Deloitte's Mr Manning continued, "Although retail was badly hit by the recession, it has witnessed administrations fall by 57 per cent over the first six months of 2010 compared with the same period in 2009.

"Retailers have experienced a more buoyant six months, following the high number of retail administrations we saw in 2008 and 2009, with many retailers now picking up the market share left by those businesses that failed.

"To date retailers have been positive, responding well to the changing environment, managing their cash flows and stock levels appropriately, as well as having successful discussions with landlords over spreading the burden of rent and service charges. I expect this level of engagement to continue, with CVAs and informal arrangements with creditors being used as a constructive alternative to administration," he added.

Experts are not entirely without their concerns about these sectors, however. They are warning against a heavy reliance on them to bolster the economy, due to similarly drastic cost-cutting measures to the UK's being implemented in other countries across the globe.

Traynor explained, "Recent weak economic data from China and the US, the challenges facing much of the Eurozone, and concerns of too many simultaneous domestic austerity programmes among G20 countries are leading some economists to question the potential for the UK to heavily rely on exports for growth." He added that sharp increases in input cost inflation were adding to the pressure being lumbered on many businesses in the sector.

Jobs and salaries in the retail trade were still facing uncertainty due to the forthcoming raising of the VAT rate to 20 per cent, which will be brought in the middle of the key January sales period 2011.

Potential ripple effects from the current levels of distressed businesses remain to be seen and could stretch far beyond the expectations of many enterprises that are counting on imminent recovery. Traynor said it was down to the government to implement a measured and thorough support system to see the country through.

"The coalition government is trying to strike a fine balance between reducing the UK's deficit and maintaining the recovery," he stated.

"Given the substantial liabilities at risk of default by businesses in distress, government support measures will need to be withdrawn gradually to avoid tipping that balance towards halting the recovery."

In conclusion, any turnaround entrepreneur needs to be fully up to date on which business sectors and types of business are in distress, if they are to make a valuable acquisition. At the Business Sale Report, we send out daily email alerts of businesses that have had winding-up petitions issued against them and this serves as a useful tool in the hunt for distressed businesses to buy.

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