The same applies to businesses. It can be hard to determine whether a business is actually insolvent or simply suffering severe cash flow difficulties. Cash flow problems, if not resolved through timely application of sufficient working capital finance, can cause perfectly sound businesses to fail. Lenders therefore need to satisfy themselves that the business's financial history is sound, it has a broad customer base, is well managed and ideally has a solid book of future orders. Proving this can be difficult for a young business, but for an established business which has a good relationship with its bankers it really should be a breeze.
During economic downturns - such as it seems the whole world is now going into - it is normal for business cash flow to come under pressure. Customers take longer to pay their bills, suppliers demand cash up front, there is an increase in bad debts and some customers say "no thanks". Well-managed companies may find themselves up against their overdraft limits and even occasionally over them. None of this necessarily means the business is going to go bust: the only one that would be likely to break a well-managed company would be the last, and then only if the market for the company's products & services completely disappears - in which case arguably its business model is insufficiently diversified. So I was appalled at this report from Ernst & Young in the Telegraph today. According to them,
Britain's recovery is being held back by a wave of "zombie" companies that should be allowed to fail but are instead undermining capitalismThis apparently is because Ernst & Young aren't seeing as many companies going bust as they would expect in the current downturn, so they think that creditors (mostly banks) are displaying forbearance towards companies in difficulties - not foreclosing on their loans, and maybe providing additional overdraft facilities.
Now, you might think this is a good thing, given my comments above about companies that are basically sound but experiencing cash flow problems in economic downturns. But Ernst & Young don't think so:
Alan Hudson, E&Y head of restructuring in the UK, said while zombie companies were still operating, they were taking market share from viable companies that should be growing and boosting the economy.....And Ernst & Young conclude that the result is that businesses that should fail aren't being allowed to.
.....because lenders continue to fund these businesses, capital is not being recycled and reinvested as it should be.
The problem with this analysis is it doesn't square with the evidence. The Bank of England's April 2012 "Trends in Lending" quarterly report states that "The annual rate of growth in the stock of lending to UK businesses was negative in the three months to February. The stock of lending to small and medium-sized enterprises continued to contract".
Note that this report talks about the STOCK of lending. That is the total of lending that ALREADY EXISTS - not new loans in the quarter. It includes drawn overdrafts as well as term loans. So if this stock of lending is contracting, not increasing, as the Bank of England's report suggests, where is the forbearance that is propping up zombie companies at the expense of new ones? If there is indeed forbearance when lending stock is contracting, then companies seeking new finance must be facing serious difficulties with credit availability. But the Bank of England's report doesn't support that:
A survey of businesses conducted by the Bank’s network of Agents indicated that for most businesses, credit availability was little changed since last summer. In recent discussions, some major UK lenders noted that demand from small and medium-sized enterprises remained muted over the quarter.This is consistent with reports that banks struggled to meet Project Merlin lending targets because there was insufficient demand from businesses for finance. Admittedly, the Federation of Small Businesses complains that businesses are still struggling to obtain finance despite recent Government initiatives, because lenders have become more risk-averse. However, this also does not square with Ernst & Young's notion that banks are propping up zombie companies. If lenders are more risk-averse, surely one would expect to see more aggressive foreclosures and less tolerance of bad debts and over-limits?
In short, Ernst & Young's arguments don't make any sort of sense. They don't square with the evidence regarding either existing lending stocks or availability of new credit, and they don't make business sense either. Foreclosing on a company that is basically sound simply because economic conditions are causing it cash flow difficulties is not remotely sensible. Bagehot's advice regarding illiquid banks is equally sound when applied to illiquid companies: "lend freely, against good collateral, at a penalty rate". So, satisfy yourselves that they have good quality assets and apply a charge over those assets, charge them through the nose for overdraft extensions and overlimits, and then lend them whatever they want. That's not forbearance - it's sound financial management.
The sharp-eyed among you just might have noticed a little factoid in the Telegraph report that might explain why Ernst & Young are so keen to see more companies go bust. The Telegraph quotes Ernst & Young's "Head of Restructuring in the UK" and their "Head of Global Restructuring". Guess what "restructuring" is? Yup, you got it. It's breaking up and sorting out insolvent companies. Ernst & Young make loadsamoney from corporate restructuring. Could it be that they are feeling the pinch themselves?
And finally, I really can't let pass their suggestion that the US Government's bailout of GM Motors in 2009 was "re-writing capitalism". As if no government has ever before rescued a failing car manufacturer. Anyone remember British Leyland?