The UK economy is coming out of recession; that now seems to be the general view of economists, politicians and business. In fact growth in the July to September quarter was 0.8%, which equates to an annual rate of around 3.2% and is the fastest growth rate of all the G7 countries, over the last quarter. Even better is the fact that all sectors of the economy – services, construction and manufacturing – are growing.
This is all great news and let’s be thankful that, at long last, there’s some light at the end of the tunnel. However for small and medium sized businesses, it presents some new challenges and I’d like to highlight some of the more significant ones.
The last recession was longer and deeper than any other recession since the Second World War. But it has shown some very different and perhaps unexpected characteristics.
Consider employment and unemployment. The following tables show changes in employment statistics between August 2011 and August 2013. I’ve extracted all of the data from official figures prepared by the Office for National Statistics.
The number of people, aged 16 – 64, who in theory could have been working has risen by 101,000 (0.3%). But the numbers in employment will always be much lower than the total number in the 16 – 64 age group, which includes students, people who have retired early, people of independent means, people who are sick, disabled etc. However, the really significant factor is that the number of people, in employment, has increased by nearly 600,000, which means that many jobs have been created or existing vacancies filled; and there are proportionately fewer people, under the age of 65, who are economically inactive.
My second table shows that the number of people, between the ages of 16 and 64, who are economically active, has increased by 700,000 over the two year period; and yet, the number of people, who are unemployed, has fallen by 90,000. These first two sets of figures seem to disprove the suggestion that the unemployment figures have fallen, due to people being reclassified as economically inactive and in receipt of other benefits. The new jobs do seem to be real and the fall in unemployment does appear to have happened.
My third table shows that the number of people, working part time, has gone up by 269,000; so some of the new jobs have been part time. However, the number, working full time, has increased by 519,000. The notion that most of the new jobs are part time is, therefore, a myth. Most of the new jobs are, in fact, full time.
All of this has been happening at a time when public sector jobs have been cut by 437,000. So the private sector has actively created over a million new jobs, most of which are full time. And this has happened, during a recession, which is unprecedented. It also means that the wealth creating part of the economy has increased its capacity, which is now likely to be underutilised. But that, in turn, means the private sector should be able to support significant growth, as the upturn gathers momentum.
However, there is considerable evidence that salaries and wages have fallen and that living standards have been supressed. Furthermore, despite the loss of nearly 450,000 public sector jobs, over the last two years, public sector jobs now command a 6% premium over private sector equivalents, according to the “Policy Exchange” think tank. This all points to many private sector employees having had no pay rises for some considerable time and to people leaving public sector jobs and taking lower paid jobs in the private sector.
Understandably, the political focus is now moving from economic growth and unemployment to the cost of living. In reality, it is quite normal for real wages to continue falling during the early stages of a recovery. But it’s also normal to see pressure building up for wage increases; and realistically, there is likely to be a period of catch-up over the next two or three years. The challenge for business is to ensure that the higher wages that ensue, are paid for through productivity improvements and don’t just inflate costs. However, that should be possible due to the extra private sector jobs and capacity that have been created.
Another factor to consider is that the rate of business insolvencies has been considerably less, during this recession, than during previous recessions. And much of this is due to the banks, which have tended to leave struggling businesses to continue struggling, rather than calling in loans and appointing administrators. But the downside is that there are now a huge number of zombie companies that can barely generate enough cash to service the interest on their debts and keep their creditors at bay. The UK’s largest insolvency practitioner, Begbies Traynor has calculated that there could be as many as 432,000 businesses in this category.
If we now start to join up all the dots, a picture is emerging of a whole raft of businesses, particularly small and medium sized ones, which have weak balance sheets, high wage costs, upward pressure on wages, suppressed profits and cash flow difficulties. Add to this, a lack of investment in infrastructure, IT, R&D, plant & machinery and training and it’s clear that many of these businesses will struggle to invest and grow as the economic recovery gains momentum. Indeed, there is a developing school of thought that, because they will act as a brake on the recovery, it may be preferable to steer many of them towards administration, thereby releasing their employees to work for stronger businesses that can fully exploit the recovery.
I don’t want to get into the political arguments of whether this is right or wrong but I do want to emphasise, to owners of small and medium sized businesses, the importance of developing robust business strategies that take account of these very real challenges. I’ve written a series of articles about many aspects of planning and managing small businesses but, on this occasion, I want to focus on the difference between cash and profit because having a clear understanding of those differences is an essential part of developing a realistic and achievable growth strategy that is able to capitalise on the current recovery.
Depending on your type of business, it is perfectly possible to run a significantly loss making business, whilst generating a substantial cash surplus; at least for a time. It is also perfectly possible to run a profitable business and have a serious cash shortfall. So let’s look at this in more detail.
First of all consider a Business to Consumer (B2C)/retail business. It receives payment for its goods/services at the point of sale. In some cases it may have even taken a deposit prior to the point of sale. So it’s generating its cash very quickly. However, it may be paying its suppliers and employees a month in arrears. The following table is a very simple profit and loss account and cash flow statement for a £1m turnover business doing precisely as I’ve described.
This business has sold goods or services to the value of £1m and has collected all of the cash from those sales during the year; but it has made a loss of £50k because its total costs have exceeded its sales revenue. However because it is paying its suppliers on net monthly terms and its wages a month in arrears, it has only paid for 11/12ths of its costs; so its cash outflow has been less than its total costs. As a result it has generated £37,500 of cash, albeit, it still owes its creditors £87,500.
If the sales and expenditure figures, in the P&L, remain the same in the second year, the cash gain, in the first year, will have been a one off because the business will pay out 11/12ths of its costs for year two plus the final 1/12th for the first year. As result, it will have a net cash outflow equal to its loss i.e. £50k.
But now see what happens if, instead of remaining static in the second year, the business increases its sales by 20%, whilst maintaining its overheads at the previous level.
It still makes a loss, this time £10k. But it benefits from collecting all £200,000 from the additional sales but only makes payments for 11/12th of the additional cost of sales. As a result it generates £3,333 of cash. So over the two year period, it has made cumulative losses of £60,000, whilst generating £40,833 of cash
If, on the other hand, the business reduces its sales, in the second year, by 10%, whilst still maintaining its overheads at the previous level, a very different picture emerges; and this is shown in the next table: –
Not only do the losses increase due to the lower sales volume, but the cash drain is even greater. Cash in is reduced by £100,000 due to sales also being £100,000 lower, resulting in a loss of £70,000. However, payments related to the cost of sales, drop proportionately less because they include 1/12th of the cost of sales from the previous year, which were 10% higher. So the cash outflow is £76,667 i.e. £6,667 more than the actual loss. Over the two year period, this means that the cumulative losses would have been £120,000 and the net cash out £39,167.
This is a classic problem for many B2C/retail businesses. They embark on a growth strategy funded out of cash flow rather than profit. Providing they don’t let their overheads expand at a faster rate than their sales, they can keep growing and maintain a positive cash flow, often for several years, whilst continuing to generate losses. However, at some point, the crunch inevitably comes. Growth grinds to a halt; sales decline for a period; the cash disappears and bang! the business goes bust. The home improvement market is an example of a sector that has a large graveyard of companies that collapsed in this way; and some of those failures were quite spectacular.
Now let’s consider the reverse problem.
Take our £1m turnover business but, this time, let’s assume it’s trading Business to Business (B2B); that it’s profitable but gives its customers ninety day terms, whilst paying its suppliers in thirty days. The next table shows simple profit & loss and cash flow statements.
Here’s a nice little business making a modest profit of £25,000 but, because it has only collected 9/12th of the cash from its sales and has had to pay out for 11/12th of its costs, it has had a net cash outflow of £143,750, which it has had to fund.
If its P&L was to remain unchanged during its second year, then it would collect £1m of cash from its sales (3/12th coming from the first year’s sales); and it would pay out twelve months’ costs (1/12th from the first year’s costs). It would, therefore, generate £25,000 of cash.
As with our retail business, the second year’s cash flow would match the profit or loss generated, providing sales and costs remained the same. But let’s see what happens to this business if it grows by 20%, whilst holding its overheads at the same level as in year one.
A sales increase of 20% would result in a profit of £65k (+160%). Cash flow would benefit from collecting three months’ cash from the previous year, as well as nine months from the second year. But cash from three months of the incremental sales, in the second year, would not have been collected by the year end, so the cash generated would only be £41,667.
The cumulative profit for the two years would be £90,000 but the cumulative cash position would show a net cash outflow of £102,083. It would, therefore, take several years of this type of expansion to recoup the initial cash outflow from the first year. And this assumes that overheads could be maintained at year one levels, which may be unrealistic.
Now let’s see what would happen if we go for a 50% increase in sales. In this case we’ll also assume that overheads would increase proportionately.
The net profit of £37,500 would be higher than in year one but would be suppressed by the additional overheads. But there would have been a net cash outflow of £6,250 because the cash from three months’ worth of incremental sales would not have been collected. So, in this scenario, there would have been two years of cash outflow, totaling £150,000 despite profits of £62,500, during the same period.
For businesses of this type, growth can be quite tricky. It needs to be planned and it needs to be controlled because, even though the business may be profitable, it may not have the working capital it needs to fund the growth it would ideally like to achieve. In a worst case scenario, it could fail due to over trading.
There are, of course, ways of funding the working capital needed to support growth; invoice discounting being one option. But however it is done, it involves a cost, which impacts on both profit and the amount of cash required. So there is a balance to be struck that keeps the costs manageable, the bottom line sufficiently profitable and the level of growth supportable.
For most small and medium sized businesses, the recovery shouldn’t be a signal for a mad dash for growth because rapid growth has its risks. For B2C/retail businesses, the risks tend to revolve around throwing money at growth because the cash is available in the bank. But costs then tend to get out of control, which hits profitability and ultimately leads to a crisis. For B2B businesses the risks tend to be around over trading, the inability to fund growth and the risk of running out of cash, which also ends up in a crisis.
Stronger businesses will obviously want to capitalise on the recovery and should of course do so; but it’s important that their growth strategies are properly planned, resourced and controlled. It’s also vital that funding is in place to support the growth plan and that the incremental sales make a real contribution to the bottom line. Whether you run a B2C or B2B business, both cash and profit need to be properly managed; and focusing on cash at the expense of profit or profit at the expense of cash is a road that invariably leads to a crisis. Get all this right and the business should grow and prosper; get it wrong and the business could be in trouble.
But what about the many zombie companies that now exist? Well, I’m afraid that some harsh truths may need to be faced. The first is that most of them are where they are due to bad management not bad luck. The second is that some of them are probably past the point of no return and just don’t have a viable future. For those that do have a chance of recovery, they really must address the underlying strategic, operational and management deficiencies that are responsible for their current predicament. Only when they’ve done this and can demonstrate a turnaround are they likely to get the support that they need, from suppliers, customers, banks and finance houses, to put in place even a modest growth strategy. But with the right approach and the right help, I’m sure that many of these zombie companies could be brought back to life.