Written By: Justin Cooper, Chief Executive, Link Market Services
The debt held by UK corporates has hit a startling high, soaring to £390.7bn. This easily surpasses the level seen before the financial crisis, and represents a jump of 69% since the low point seen in 2010/11. Debt is not necessarily a bad thing in its own right, but the record level of borrowing begs several vital questions. What is it being used for? Is it sustainable? And are companies’ balance sheets in better shape than prior to the last financial crisis?
After years of easy credit, companies ended 2008/9 with relatively high borrowings. However, when the financial crisis took hold, many were unable to roll over existing financing arrangements on terms anything like as favourable as before, while others were unable to borrow at all. Finance Directors (FDs) responded by using the cash their businesses were generating to pay down their debts, especially short-term debts, or even issued new shares to investors to raise capital.
Since then, firms have gradually returned to their old ways, taking full advantage of the rock bottom interest rates on offer since the credit crunch to finance their operations, investment, and in some cases, dividends to shareholders. FDs face incredibly complex decisions when it comes to allocating capital, especially in the times of poor profit performance that we saw in the last few years. Faced with the demand from shareholders to continue pay-outs, and needing also to invest in new assets and fund acquisitions, many companies have had to increase their borrowings significantly to avoid cutting their dividend. Overall, in the three years to the end of March 2018, UK companies paid out £263bn in dividends, having made profits of only £316bn. In the same three-year period their net debts rose by £122.6bn.
Debt is by no means negative to a business. It is, after all, a relatively low-cost source of finance, cheaper than equity, and has the ability to enhance shareholder value. It’s vital, however, that debt is affordable and sustainable. Looking at these attention-grabbing numbers, many will be left questioning how realistic it is for UK companies to maintain these levels of borrowing.
Firstly, sustainability depends on the nature of the company, and its sector. In industries like utilities, or consumer staple companies like tobacco, steady and reliable cashflow can support a higher level of debt. By contrast, cyclical businesses are less well placed for a larger debt burden.
Secondly, it must be seen in context by investors. When we look at the gearing of companies, the so-called debt-equity ratio, the actual burden of debt is improving. As the credit crunch hit, UK plc collectively had a very high debt/equity ratio of 89%. Total debts of £402bn were almost equal in value to the amount of equity accumulated on corporate balance sheets. Since then, even though the absolute value of debts has continued to grow, healthy global growth has meant higher profits. That has both brought gearing levels down to a more comfortable 73%, and means that interest costs and dividends are much more comfortably covered by profits.
Affordability of debt is improving too. Interest costs consume only £1 in every £8 of operating profit, a figure which had been as a high as £1 in every £5.70 in 2016/17, on the back of improving profitability. However, as global interest rates climb, this figure has the potential to creep up.
Meanwhile, FDs continue to shift from short-term to long-term debt, and cash balances are back on the rise. At the time of the recession, 26% of all UK debts were due within a year. By 2017/18, that figure had fallen to just 18%. Meanwhile, cash piles are 39% larger. As a result, companies are far better positioned to weather a sudden disruption in the supply of credit than they were before.
The economic recovery since the credit crunch has been slow, but very long, and some commentators suggest the cycle may be drawing to a close. Total borrowing may continue to rise as it’s a vital part of the investment financing-mix, but gearing, or the burden of debt is on the wane. Companies are currently well able to service their debt. In these times of political and economic uncertainty, and the prospect of higher interest rates, investors may well prefer to see gearing decrease further. Company boards need to be financially prepared for all eventualities, whether that be falling profitability, or an increase in the cost of finance. Affordability and sustainability of debt is undoubtedly vital to a company’s survival and success.