As the UK economy struggles, look out for highly leveraged businesses
In this ninth instalment of our Xenia Xtra Series, Risk Development Executive Roberto Simone explains why it’s so important to keep track of highly leveraged firms in difficult times for the UK economy.
There’s no doubt 2023 will serve up more huge challenges for businesses, with the UK economy showing no signs of letting up. Firms are simply not enjoying the footfall and numbers they were once familiar with. Driving forward as a company has become much more challenging and complex.
As I’ve repeatedly highlighted in this Xenia Xtra series, the current economic climate heightens the need for deeper diligence when monitoring, reviewing or considering trading partnerships.
In these difficult times, there are key indicators that demonstrate the health and solvency of any business - and one of the most important and critical is how leveraged they are in terms of their reliance on borrowings, both short and long term.
Macroeconomic factors to consider
Borrowings, in fairness, are a necessary evil because without support from a financier or invoice discounting facility, cash flow can be hampered, especially given the current uncontrollable macroeconomic factors at play. Inflation, while showing signs of falling, remains five times the Bank of England’s 2% target rate, while interest rates are at their highest in 14 years.
That’s why those highly leveraged businesses need to be watched with precision. When any company fails, it’s often down to a number of fundamentals including their inability to settle any debt obligations, or interest that needs to be serviced.
At the end of the day, many businesses in today’s climate will need to borrow money to grow their business or ensure it has the necessary cash flow to pay for goods to keep the business ticking over. But at the point where interest rates have started to rise, a wave of problems may eventually surface, especially for those unable to meet covenants that are set in their borrowing parameters.
Those businesses that are highly leveraged are the ones to take note of because when any firm is too reliant on borrowings, and not reinvesting their funds throughout the business or generating the return required, the solvency of the business starts to wane and is no longer comparable to the financing being used to fund and fuel the business.
Lessons from Toys “R” Us
Toys "R" Us is a perfect example. To fund the business’s growth in its successful years, it was mainly financed through leveraged facilities and private investment. As it evolved and market changes occurred, with competition changing and becoming more fierce, Toys “R” Us’ deteriorating credit risk started to become more prevalent because of its reliance on feeding the business through funds and financing.
And yet its numbers, footfall and market share was still remaining in reasonable shape. What followed was a high-profile demise in 2018. What had gone from a very strong, financially sound and highly regarded business is no longer visible on the high street (though the business was revived in 2021).
There was a Rubicon in the case of Toys “R” Us - as is the case with every business that continuously stimulates and fuels the business with credit and finance. This is particularly evident when mainstream banks are invested too long and the trend in results is moving in a direction posing concern. At this point, an institution would rather cut their losses rather than run the risk of losing more expansively. After all, these too are businesses, and need to ensure they are getting a return on their products and services. Without the right yield they just won’t continue in many cases.
In essence, the businesses that exercise strong risk management and ensure their borrowing profile remains in good stead will be able to encounter and absorb any challenges or deficiencies that come their way. They are the ones that hold a sound investment grade, eventually prevail and obtain further financing needed - even amid the significant challenges ahead. For more on this, read our previous blog on sound risk management.
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