As another economic downturn – or will it become a full-blown recession? – gathers pace, Nemesis is waiting in the wings to teach a lesson or two to companies grown complacent on the comparatively easy pickings of the last few years. Business failures reached record peaks in the recession of the early 1990s as the goddess of divine retribution went about her work. Already, she has selected her first victims for the new downturn. There are, of course, many urgent questions for those businesses facing wipeout. But for the thousands of fundamentally sound businesses that will pull through the new downturn in various degrees of good health, there are also key issues. For business failure is like a contagion, spreading its sickness indiscriminately even among the healthy. During the last recession, many companies suffered from the failures of others; bad debts rose, cutting into profitability; valued suppliers disappeared, cutting off sources of key components; normally wise FDs were suckered into making acquisitions at seemingly attractive prices only to discover they had bought themselves into trouble. The problem was that what seemed like solid – even high-flying – businesses crashed, often without warning. Consider the case of Sock Shop, a corporate icon of the Eighties, rising from nothing to become a growth wonder. In early 1989, nothing seemed to stand in its path with founder Sophie Mirman announcing expansion in North America. Within months, it was gone, leaving bruised investors and suppliers in its wake. It blamed over-ambitious growth plans and a hot summer – with too many bare feet – for its demise. But, says Richard Taffler, professor of accounting and finance at the City University Business School, the warning signs were clearly visible much earlier. Nobody bothered to read them. The company’s early strength rested on a buoyant cash flow. When that slowed, the underlying picture of its financial health changed dramatically. Using a “PAS score”, derived from a methodology which analyses a company’s cash flow, working capital, financial risk and liquidity, Sock Shop was a basket case by early 1989. Only two years earlier, it had been riding high in its industry sector, even though issues such as working capital and liquidity were weak. The problem was nobody seemingly looked at these hard figures. Bedazzled by Sock Shop’s early success and the attractive persona of its founder, investors and suppliers were backing it until the end. Will it all happen again? It looks as though it will, unless FDs start to take a more rigorous view. According to David Wilkinson, a partner in the reorganisation services group at Deloitte & Touche, it is time to take off the rose-tinted spectacles when looking at major customers and suppliers. “You have to be a bit more cynical and a lot more down to earth,” he bluntly advises. “When times get tougher, you need to be much more cautious in your assessment of the situation.” The problem is that when companies slide into difficulties they tend to become much more sneaky about their business tactics. Customers disputing invoices with bogus or trivial complaints to delay payment is one tactic. Suppliers invoicing for goods early – “in error” – and then raising a credit note after their year-end, so that the sale appears in the previous year’s figures, is another. David Lovett, a corporate finance partner at Arthur Andersen, recommends: “The task of the FD is to keep a weather eye out for these sorts of signs and decide whether they are symptomatic of an underlying problem.” The problem for the FD is that picking out the ailing from the healthy is not a straightforward task. Some of the sickest look as though they could run a marathon, in corporate terms, shortly before they expire. Terry Smith, a partner at stockbrokers Collins Stewart and author of the forthcoming book Corporate Pathology (see panel, below) says that one warning sign can be “improbably good companies”. He says: “You need to be wary of companies that are bucking the trend in their industry and you can’t work out why.” He cites the case of BM Group, an earth moving equipment distributor, which had a margin of 9% before taking over Blackwood Hodge, a similar company with a 5% margin. Mysteriously, BM Group’s margin improved to 11%. Digging deeper uncovers the reason: BM Group made use of the reorganisation provisions in its accounts to cover other costs. Sometimes there is a more sinister explanation. In the depths of the last recession, Spring Ram Corporation, the manufacturer of kitchens and doors, was posting operating margins of 17% while other building industry suppliers were on the floor. Explanation: false accounting. Smith counsels that improbably good companies often have improbable explanations for their success. “It really pays to calculate one or two quick ratios to get a feel for a business,” he says. “For example, what is the income and what is the cover for fixed charges such as interest and rent?” It may be excusable ignoring those basics in a bull market, but there are greater dangers when economic circumstances become tougher. So if you are dealing with key customers or suppliers, what alarm bells signal that things may be going wrong? First, take the customers. Lovett, whose book Corporate Turnaround (co-authored with London Business School professor Stuart Slatter and published by Penguin in the new year) says the “amber lights” are the obvious signals such as late payment or customers seeking to renegotiate payment terms. Wilkinson agrees with Lovett’s list and adds that the annual report can also provide pointers – for example, unexplained slowdowns in capital expenditure. Another sign is a company suddenly switching to factoring its invoices. “People normally tend to use factoring houses as either a secondary source of finance or sometimes almost as a last resort,” says Lovett. Though the factoring houses might disagree, “a high proportion of the companies that subsequently end up in deep trouble have their debts factored.” One of the biggest problems is the way payment trends almost imperceptibly tend to creep outwards during economic downturns. What starts off as 60 days slips to 65 days, then to 70 days. Wilkinson points out this can be a more difficult situation to manage than the customer whose payments suddenly jump from 60 to 90 days. It also raises a difficult question of tactics about how a company should manage a major customer whose payments are slipping. This becomes an especially difficult issue where the customer represents a sizeable portion of a company’s business. Waving goodbye to the customer may not be such an easy option when the business is more difficult to replace in a downturn. Both Lovett and Wilkinson agree the starting point is to know the customer well. “The first step is to understand the cause of the payment slippage. If you feel it is the result of financial difficulties, you may need to re-rate both in terms of the amount of outstanding credit and the payment length,” he says. Where a major customer has already exceeded its credit limit but is trying to bring the situation under control, Lovett suggests dividing the problem into two halves. “Suggest that the customer keeps to normal payment terms within the agreed limit, but negotiate a repayment plan for the amount over the limit,” Lovett says. The sad fact is that this somewhat depressing management activity too often gets pushed on to the back burner in favour of other tasks. Wilkinson says: “Companies are run on a much leaner basis than before. The FD is already working long hours and the prospect of having to spend time negotiating payment terms with key customers is a considerable extra commitment.” At the end of the day, it is always difficult to lose a customer. But as Lovett cautions: “A sale isn’t a sale until you have the cash in your bank.” But it is not only among customers that business failure can cause problems. If key suppliers go down, they can leave a company looking for difficult-to-replace components or supplies. So it is also important to monitor the health of these key suppliers during any difficult economic times. The signs are often similar to those of the customers – although seen, as it were, from the other end of the telescope. Unfortunately, managing the situation also soaks up management time. Where a key supplier is in difficulty, a company may have little option but to be supportive to it. Lovett suggests paying it more quickly. But he cautions: “You must satisfy yourself that in doing so, the supplier doesn’t use the money to pay somebody else off. Help should also be on the basis that the supplier provides an open flow of information about its position.” Clearly, if a company wants – or needs – to get closer to its supplier to support it through a rough patch, there is a range of options from informal partnerships through to a strategic alliance with an exchange of directors on the board. And this raises a third issue, beyond customers and suppliers, that can be more difficult to manage in a downturn – mergers and acquisitions. One of the temptations of recessions is that a number of companies come onto the market on “fire sale” terms that may, on the face of it, seem too good to miss. In every case, directors need to ask themselves whether they understand fully what they are buying – and why. “In the main,” Lovett says, “the value in a merger and acquisition stays with the vendor in the early days. This means if you are embarking on an acquisition in difficult trading times, be very careful about the price you pay. You should not presume that you will be able to release synergistic benefits from the merger or acquisition quickly.” What aids are available for members of the financial team as they set about collecting more reliable information about the financial health of key customers, suppliers and business partners? The first source is the information that the company has within its own organisation. The company will already have contacts at many levels with customers or suppliers. It needs to become more systematic about the way in which it gathers information and turns it into intelligence. In many cases, it is this home-gathered information that will provide early warning signs more quickly than external sources. Of the external sources, Dun & Bradstreet is by far the best known and most widely used by companies of all sizes. It collects information from sources such as returns filed at Companies House and “trade tapes” – essentially sales ledger data – from participants in its surveys all over Europe. From this and other data, Dun & Bradstreet provides a one to five credit rating on any company – one signifying “minimal risk” and five “insufficient data to assign a rating”. Another approach, widely used in the investment community and by major accounting practices, is to assign Z scores to companies. The Z score is a measure of a company’s financial health based on a complex statistical technique which takes into account 80 financial ratios including profits to current liabilities and current liabilities to total assets. Syspas, a UK consultancy which specialises in this technique, uses Z scores to derive a PAS score – the number that prophesied the Sock Shop demise – which is a listing of companies ranked by their Z scores. The ranking runs from 100 (rock solid) to one (highly risky). Martin Kelly, Syspas’s chief executive, says he is not yet aware of any British non-financial companies that use Z scores. But he believes the methodology could have wide applications for ranking a company’s customers and suppliers. There is no doubt that systematic information gathering and statistical analyses have an important part to play in identifying and reducing exposure to business failure in others. But Terry Smith also believes there are some other visible signs. “Be very wary of companies that feel the need to have flashy annual reports with lots of photos of people from far-away places,” he says. On that measure, there could be some very awkward looks around boardroom tables. Terry Smith on how Charterhall mapped its own downfall Few companies provide in their annual report a diagram giving you a map of how they are about to go wrong. Charterhall was the acquisitive vehicle of Russell Goward, one of several Australian “corporate raiders” who roamed around the UK in the 1980s’ bull market investing with all the subtlety of Indiana Jones, before most of them were blown away either by the crash of ’87 or the recession of 1990-92. Charterhall exemplified a trait which might be described more as folie de grandeur. For the year to June 1989, it reported turnover up from £28.7m to £103.4m – a mere 260% increase which reflected the acquisition of Marks & Spencer supplier Corah and the footwear retailer Lennards. Charterhall’s annual report for the year to June 1989 made instructive reading. It acknowledged the “high interest rates and the deteriorating world economic outlook” which led it to a “counter-cyclical search for unfashionable, friendless and fragmented industries”. Unsurprisingly, it found quite a few of those to invest in as the world moved into recession. “Charterhall has never made a hostile bid and we would prefer to avoid them in the future. They are extremely upsetting to the management of the target company.” Well, best to avoid upsetting them, eh? But no need to worry “because we prefer friendless, poorly performing industries; agreed bids are relatively easy to obtain”. It never seems to have occurred to Goward that just maybe the rest of the world was right in leaving these companies friendless and he was wrong. The annual report continued: “Charterhall is a very conservatively run organisation.” Six months later, the company reported a loss of £26m, its net assets were negative after goodwill was written off on acquisition, debt was £100m and Westmex, the Australian company which had guaranteed its debts and owned over half Charterhall’s shares, was in liquidation. Isn’t self-knowledge a wonderful thing? But the piece de resistance, in my view, was the diagram. Just in case we Poms hadn’t followed the exposition of its brilliant investment strategy, the chairman’s statement was complete with a diagram of “a typical investment cycle” written in a Learn Yourself Economics standard of explanation of how to play it: “Everything in nature goes in cycles and investment markets are no exception. Just as night follows day and spring follows winter (even though it may be difficult to tell which you are in during the “transitional” periods) the rough sequence of events in investment markets are just as certain. The reason for including the following chart in the annual report this year is to ensure that shareholders are fully aware that we are near the bottom of the current investment cycle. With the economy in recession, now is the time to buy good-quality listed businesses.” Sadly, while Goward had the broad theory correct, he seemed to have overlooked the point that most recessions are not over in six months. Remember he was making these statements in September l989, just as we were entering recession and some three years before the recovery was fully established. It’s also not entirely clear to me how textile and shoe companies fit the description of good quality listed businesses. But this is nit-picking in comparison with the big picture, which is that when someone uses the Annual Report to tell you, complete with diagrams, that they understand the business cycle better than the collective intelligence of the market you know what’s about to happen next. Best that they don’t do it with your money though. By 1991, Charterhall was bust. Terry Smith is the author of Accounting for Growth. This is an extract from his next book, Corporate Pathology, to be published by Century in spring 1999.