Covid-19 has prompted talk about recession again. For companies without a margin of safety, this will require action from auditors and finance teams, says Jane Fuller
This article was first published in the April 2020 UK edition of the Accounting and Business magazine.
This was supposed to be the year when the global economy muddled through nicely in the run-up to the US presidential election in November. Complacency was fanned by an easing of US-China trade tensions, a better outlook for Europe and a stimulus package in Japan.
But by early March the spread of the Covid-19, and of activity-stifling measures to counter it, had caused forecasts to be slashed.
The OECD, for instance, reduced its central growth forecast from 2.9% to 2.4% but warned that an intensification of the virus could halve projected growth to 1.5%.
Talk of recession is back. For businesses, which often find it difficult to curb costs quickly, the unexpected threat to sales spells falling profits and a hit to cashflow. For those with money in the bank or ample scope to increase borrowings, this is disappointing but not life-threatening. The trouble is that far too many companies lack this margin of safety.
Investors hunting for yield have piled into corporate bonds. But the era of blue-chip AAA borrowers is long gone: a tiny number retains the top rating. Instead the past decade has seen a doubling of the amount of corporate debt sitting at the bottom of the investment grade category.
In the FTSE 100, for instance, at the end of February, S&P rated more than a third of constituents at the three BBB levels that count down towards non-investment grade – or ‘junk’.
What does this erosion of the margin of safety mean for accountants? If they are auditors, they should redouble scrutiny of the management cashflow forecasts that feed into asset valuations. It may even mean noting that the going concern basis for the accounts is dependent on the forbearance of lenders. Some companies will be tipped over the edge.
Within companies, finance teams will be instrumental in seeking cost cuts, which may involve upfront spending. Cutting dividends, share buybacks and capital spending plans will also be in the mix.
Of more strategic interest is whether assets can be sold to raise funds, although the shrinkage may diminish future profits. If the chief executive is loath to put once-prized acquisitions on the block, more realistic finance directors will need to speak up or step up.
Most intriguing is whether the long-running cycle of ‘de-equitisation’ is over. Central banks have little ammunition left to suppress interest rates. In any case, what matters to companies is the premium they have to pay over risk-free rates and this has risen significantly.
With profits falling, covenants based on ratios such as net debt:ebitda (earnings before interest, tax, depreciation and amortisation) or interest cover (by operating profits) may be tested.
Time for finance teams to dust off their knowledge of equity issues to rebuild balance sheets.
Jane Fuller is a fellow of CFA Society of the UK and co-director of the Centre for the Study of Financial Innovation.
"If the CEO is loath to put once-prized acquisitions on the block, the more realistic FDs will need to speak up or step up"