The recent spectacular collapses of Peacocks and La Senza have shone the spotlight on the funding of UK retail businesses. These otherwise relatively successful store chains collapsed under the dead weight of impossible debt burdens. Their net debts were equivalent to £615k and £422k per store respectively.
These untenable financial scenarios were part of a typical private equity structure, designed to magnify the return for the equity part of the balance sheet. It’s an approach that looks less than ideal now that the financial tide has gone out and we can see who’s swimming naked.
Recession after recession, some truths remain. One is that there needs to be a sensible balance between equity and external funding. As many overly adventurous entrepreneurs keep discovering to their cost: equity is locked in, but lenders can take their toys home.
The old-fashioned term for this risk balance is gearing. It must be nearly 40 years since I first heard a bank manager say to an eager borrower that he couldn’t increase their overdraft facility because it would mean that the bank had more at risk than the shareholders.
Looking at a sample of 15 of our top retailers (we’ll publish the full table later today), it is fascinating to see how few of them transgress the broad principle that the debt of a company should not normally exceed its net worth. Just four of them have gearing in excess of 100 per cent, although two more have gearing ratios of 99 per cent.
There is of course sometimes an excuse for high gearing. Investment in property assets has always supported higher borrowings, as have strong levels of profitability. The latter is more risky, especially in challenging times for retailers – like now.
Looking at our top six most indebted retailers close to or above the 100 per cent gearing, two have acceptable levels of financial health, but four are in or very close to our Warning Area, with H-Scores® of 25 or less out of a maximum of 100, indicating financial vulnerability and, statistically, a one in four risk of future failure or restructuring.
Is there a pattern to the retailers carrying the highest debt burdens relative to their net worth? It’s hard to discern. Our list ranges from a department store format to CTN corner stores, and a home shopping business. One’s in fashion, another is home products, while two cater for low-value convenience purchases. These businesses have very different retail margin characteristics. Interestingly, none are in food retailing.
The lesson seems to be that high gearing comes at a price. It can be supporting property assets, where valuations may become threatened by the relentless march of online sales which devalues the benefit of bricks and mortar retailing. Or it may demand higher profit margins than can be achieved in the current retail climate, as Peacocks and La Senza found out.
Either way, high gearing in UK retailing is no less risky a strategy right now than it is in most other sectors. Sensible management teams will be seeking to reduce rather than increase their debt exposure, and sooner rather than later.
Nick Hood is head of external affairs at Company Watch.
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