For the past twenty or so years, businesses have shifted their funding strategy from equity to debt, not just for growing their business but as a way for shareholders to extract profits and reduce the amount of cash tied up. Some might regard this as efficient, but it may not be prudent and give a clue to the future of company failures.
Despite the use of debt, since the 2008 Great Financial Crash, the banks have been forced to rebuild their balance sheet and so have been bucking the trend by raising equity and retaining profits to improve their liquidity ratios.
As an observation, we no longer seem to report or even talk about company liquidity ratios such as the quick (acid-test) ratio or current ratio. Indeed how many people have heard of Holmes & Sugden who in 1979 produced the ‘accountants’ bible’ on how to analyse accounts (Interpreting Company Reports and Accounts). It too is no longer sought after having originally been updated every four years, the latest edition, the ninth was last updated in 2005.
I accept that a growing business might use debt such as factoring or invoice discounting to fund growth but the costs are rarely justified for funding flat-lining or declining revenues. The use of debt, therefore, suggests that shareholders don’t really believe in their business or its future since they would rather extract profits instead of reducing debt.
The current financial climate, where the outcome of Brexit negotiations is still uncertain, a lack of confidence might be justified but I am not convinced that now is the time to run down balance sheets. Nor is it a time to pursue growth. Instead, I would advocate a relentless pursuit of productivity through efficiencies and improving systems.
Tony Groom, K2 Business Partners, Chief Executive
To help businesses I have produced a useful guide which can be downloaded here.