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Retail: when debt becomes toxic

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Peacocks was carrying a debt burden of £615k for each of its 1,000 stores, half of it with an interest rate of 17 per cent under a classic private equity structure. 

La Senza owed £422k per store. With retail sales and profit margins under ferocious pressure, this was clearly unsustainable.

But debt is not necessarily a killer. The issue is how it fits into the mix of assets and liabilities which support and finance a retail company and how the interest burden relates to sales and profitability. Bitter practical experience has long taught that there are certain norms, which are exceeded at the peril of even the most competent management teams.

These financial truths apply to all retailers, whether big powerful quoted companies or family-owned single site operations. In between are many well developed mid-size businesses, who demonstrate that debts can be part of a success story, provided they are kept under control.

The table (click on image below to enlarge) shows the ten mid-size retailers in the £30m-£50m turnover bracket with gross debts of £1m or more and the strongest H-Score ratings (see how they are calculated here) under the Company Watch financial risk assessment system.

All of these businesses are carrying significant gross debts. But once their cash holdings are netted off, their gearing ratios in relation to their net worth (the shareholders’ stake in the company) are, with one exception, well within accepted tolerances. 

Ultimately, they are using debt to invest in their businesses, but not too much of it.

The other characteristic of this set of healthy debt exploiters is that they are substantially profitable after covering their interest payments, which completes the virtuous circle of sensible financial management, for which all external stakeholders look to reassure themselves that a company is safe to do business with.

It really is very simple. Quite rightly, suppliers, their credit insurers, landlords and bankers ask themselves two simple questions: can the retailer pay the interest on its debts and are the lenders taking more than their fair share of the risk? These are key considerations in these difficult times after the global recession and with the threat of a double dip, when liquidity is scarce in the financial sector and risk awareness is at an all-time high.

There is a growing debate about the relentless march of online retailing, which grows spectacularly each year. Many critics fear for those retailers plagued by the “too many bricks and too much mortar” syndrome. The suggestion is that online-only retailers have a major advantage without the heavy cost burdens of physical store locations to support.

A brief look at the online-only model suggests that the financial health of its exponents is not necessarily more robust. Of the three examples shown in the table below, two have below average H-Scores, while one is firmly in the Company Watch warning zone with a low score of only eight out of a maximum of 100. They may be profitable, but the problems are obvious: high gearing or negative net worth. Heavy investment in intangible assets, such as sophisticated software platforms, also dilutes financial strength. This is a business model which still needs time to develop and mature. 

So the lesson for retailers is that debt is not necessarily toxic, but it must be kept in balance with net worth and to carry it, the business must be profitable. 

Some business realities are inescapable and do not change with modern commercial fads or fancy gimmicks.

Debt burdens: mid-sized retailers

Nick Hood is head of external affairs at Company Watch.

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