Overview

In early October 2011, Baker Tilly commissioned YouGov to conduct its Outlook 2012 survey to gather the opinions of business decision makers.

Our aim was to understand the issues that are affecting small and medium-sized enterprise owners/directors in the current economic climate and their concerns about matters including business confidence, the anticipated challenges and opportunities for their businesses during 2012 and their top strategies going forward. 614 respondents drawn from across England, Scotland and Wales completed the survey.

At the time of our survey, business confidence for 2012 had fallen back to 2010 levels. Over half of respondents were more confident about the prospects for their own businesses than they are about their industry sector. However, similar proportions anticipated their sales, gross margins and profits will remain at similar levels to 2011, echoing the views of a number of economists and commentators that the economy is likely to remain stagnant in 2012.

Respondents’ business strategies reflected a cautious outlook. Improving internal processes and systems was top of the list, with cost-cutting in third place. Developing new products and services and selling into new geographical markets were also among their top plans, suggesting that they are intending to tackle the challenges in the UK and global economies proactively to grow their sales.

More than 70% of respondents said that their banking needs during the previous year had been met. Moreover, fewer than 10% said that their banking needs had not been met. This seemingly contradicts the widespread media coverage surrounding the failure of banks to support small and medium-sized enterprises. A quarter of businesses expected to raise finance in the coming year, of which more than a third would do so by means of traditional bank lending. Asset-based lending was the route chosen by 25% of respondents, while 18% said they expected to raise funds through private equity or venture capital funding.

Continuing the trend of what we saw in our survey a year ago, the overall mood of respondents was again one of caution against a background of uncertainty. With huge volatility in the eurozone, US and global economies, this mood may quickly change.

Embattled confidence

In brief:

• Overall business confidence has dropped across all areas, back to levels similar to those seen in 2010.
• Business decision makers tend to feel more confident about the prospects for their own business in 2012 (54%) than about their sector (27%) or their region’s economy (18%).
• Prospects for sales, gross margins and profits are that they will remain at levels seen in 2011.

A high proportion of respondents to our Outlook 2012 survey do not expect an increase in their sales, gross margins or profit in the year ahead. Our research for the Baker Tilly/Company Watch SME Distress Monitor  published in Autumn 2011 found that almost a quarter of SMEs across the UK saw a drop of over 50% in their profit before tax levels, according to their full 2010 filed accounts.

In addition, over a quarter saw a decline of 10% or more in their sales figures. The report concludes that despite all efforts to preserve top-line revenue, global inflation and consumer caution is severely impacting the bottom line of businesses, whatever their industry sector.

Outlook 2012 shows almost half of respondents have learned hard lessons and are seeking greater efficiencies within their businesses by improving systems and processes in order to achieve performance that is either as good or better than last year. This may not be a bad thing for their businesses in the long term but it means that growth is likely to be subdued in the immediate period.

However, this masks some additional trends that are both positive and negative. On the one hand, reports Rob Donaldson, Head of M&A and Private Equity: “Many businesses we are dealing with are in good shape. Trading in a recessionary environment is not a surprise to them anymore. They have taken action on costs, strengthened their balance sheets and garnered their cash.” He adds that, on the other hand, businesses face an uncertain outlook coloured by worries over the impact of sovereign debt, the future of the euro and sluggish growth in the global economy. Therefore, they are loath to invest, though some bolder business owners and managers may be ready to take advantage and make acquisitions, for example, ahead of an upturn. Many businesses are, however, stockpiling cash having repaid debt, so reducing their dependency on the banks.

This is the good news. But there are many other businesses that are in a worse condition according to Guy Mander, a Partner in Baker Tilly’s Restructuring and Recovery team in Birmingham. Because of inflationary pressures, resulting in cost burdens that they are unable to pass on to their customers, these companies are living day to day, he says.

“While some businesses that have survived the recession are resilient and are in good shape to move forward, others are merely hanging on. They may have used up the cash reserves desperately needed to survive. They may also be benefiting from interest-only arrangements with their banks or have taken advantage of Time To Pay agreements with HMRC, both of which they may or may not be adhering to. However, any increase in creditor pressure may force several over the edge.”

For some of these companies, confidence in their businesses may be misplaced. What lies in store could be further cost-cutting, job losses and, potentially, insolvency. However, a degree of ‘corrective’ fall-out through insolvency may in fact act as an effective medicine for the wider economy, freeing up markets for stronger, more competitive, businesses to prevail. An increase in insolvencies may also result in opportunities for acquisitive businesses with cash to spend to buy market share or bolt-on operations, thus re-utilising otherwise moribund resources.

Managing risks and controlling cash

In brief:

• Improving internal processes and/or systems is the top priority for business decision makers.
• 40% of businesses introduced new risk management procedures in 2011.
• Of these, the most common centre around credit control and implementing and monitoring more stringent risk registers/procedures.
• Other top priorities include the development of new products/ services and direct cost-cutting.

In light of the external challenges besieging businesses, managing risks, costs and working capital as efficiently as possible has become imperative.

Processes and controls
Although we are already several years into the economic downturn and many businesses have already consciously tightened their internal operations during this period, improving control and efficiency remains a key point of focus for business leaders both now and throughout 2012.

40% of businesses said they had introduced new risk management procedures in 2011 and improving internal processes and systems was identified as the most popular strategy for 2012 among those surveyed. Cutting costs and consolidating products or suppliers were also listed among the opportunities that respondents identified for their businesses.

Focus on risk procedures
Scrutinising the underlying infrastructure of the business – including its systems, controls and unglamorous back office procedures – needs to be an ongoing activity, according to Mark Taylor, Baker Tilly’s Head of Process Improvement. “Are these suitable for what the business needs now and for the future?” he asks. “From our experience, common key business processes to examine include the purchase to pay process, sales orders to cash and, where relevant, stock management.

These all contribute to the important task of managing the working capital cycle – the lifeblood of any business. Such processes may have been under the management spotlight for some time but many companies are still not exercising sufficient control.”

Finance and IT are other key back office functions that Mark says all businesses need to assess constantly to ensure they are delivering real value for money to the organisation. For many businesses, 2012 should be the year when they bite the bullet – taking fresh action to re-shape their internal systems and processes.

Fraud
Fraud discovery tends to increase in times of economic stress. It may involve a member of staff, customers or suppliers. While internal checks may be easier to carry out, Forensic Services Partner, Marcus McCaffrey warns that businesses should look carefully at their relationships with trading partners.

“You might, for example, find a supplier is trying to compensate for a downturn in business by providing inflated invoices for services that may not even have been delivered,” he says. “However, if the business has not previously carried out an audit rights inspection as provided for in the supplier contract, it may not have been spotted before.”

Working capital management
This is one process that many businesses could improve. “In the course of working with many different businesses, we frequently come across deficient credit control measures,” says Restructuring and Recovery Partner, Sarah Batchelor. “We encourage them to collect cash more quickly through improving systems, to incentivise their customers to make early settlement and to issue invoices promptly.”

Businesses often measure debtor days but the process of sending out invoices can often occur long after the sales activity that generated the invoice. As a result, cash is not realised as quickly as it could be. Many businesses can improve their working capital significantly by being more rigorous in these simple business disciplines.

Overall, evaluating process and risk management effectiveness should not be seen as a single event. It is a key part of management control and should remain under ongoing scrutiny to ensure it is fit for purpose, especially during a time of economic austerity.

The pursuit of new money

In brief:

• Only a quarter of business decision makers expect to raise additional finance in 2012.
• Of these, traditional bank lending is the preferred option (37%), followed by asset-based lending (25%) and private equity/venture capital (18%).
• More than two-thirds (70%) of respondents say all or most of their business needs have been met by their bank in 2011.

While bank lending remains constrained, the findings of our survey raised a number of issues concerning access to credit for business owners and managers.

Banks
A quarter of respondents to our survey expected to raise additional funds in 2012. While more than a third of these said that they preferred to raise such funding via traditional bank lending, a question mark hangs over their ability to do so.

The Bank of England’s October Trends in Lending reported that “the stock of lending to UK businesses overall contracted in the three months to August, as did the stock of lending to small and medium sized businesses…” Given the findings of the Baker Tilly/Company Watch SME Distress Monitor , released in November 2011, that businesses are experiencing large falls in sales and profits, it is unsurprising that demand for lending is falling. “Servicing debt remains crucial to business survival,” says Tony Wright, Baker Tilly Restructuring and Recovery Partner. “It is particularly concerning that our research shows almost one in every four UK SMEs has a liquidity ratio below one, indicating insufficient resources to meet their short-term debt and payable liabilities. Therefore, many businesses may be reluctant to add to their current debt levels.

Our survey result that found 70% of businesses are satisfied that their business needs have been met by their bank in the last year may simply be a reflection of fewer applications for new loans. Despite the availability of interest-only bank arrangements, some weaker businesses, unable to satisfy the terms, will not be in a position to raise further debt and may have very low cash reserves. Consequently, they are effectively zombie companies without a convincing case to offer bank lenders,” Tony concludes.

Meanwhile, loans made by the big five business lenders – Barclays, HSBC, Lloyds, RBS and Santander – under the Government’s £190 billion Project Merlin were broadly on target after the first three quarters of 2011 at £157 billion. Of this total, £56 billion of the £76 billion earmarked for SMEs was also in line with the overall plan.

This sounds positive. However, as Baker Tilly’s Head of M&A and Private Equity Rob Donaldson explains, while there is a lack of demand for business credit, the big five lenders and Project Merlin nevertheless cannot fill the gap left by foreign lenders who have quit the UK business lending market.

The businesses that do intend to raise new finance often do not present their case to bankers in a convincing manner. “Reliable management information and the ability to produce accurate, timely forecasts are invaluable when dealing with the company’s bankers,” says Peter Cooper, Head of Baker Tilly’s Corporate Restructuring Team. “It allows bankers to gain an in-depth insight into the business as it is operating today and how it plans to move forward. Out-of-date, incomplete or erroneous financial information does not enable bankers to make a true assessment of the state of the business and undermines management credibility.”

Alternative sources of funding
Rob Donaldson goes on to explain that the dearth of bank funds has driven business owners to look again at their funding needs. Some have concluded that long-term equity has a role to play in their businesses. Rob adds that the long downturn and recession has forced entrepreneurs to re-price their businesses to take account of current market conditions. These two factors, the willingness of entrepreneurs to consider some dilution and more realistic pricing have opened the door for private equity to take up some of the funding slack. Moreover, non-banks, such as newly raised mezzanine lending funds are also now playing a larger role. Additionally, asset-based lending (ABL) is rapidly filling some of the vacuum left by traditional bank funding. “Lenders secured against receivables or other business assets such as inventory and plant and equipment have been rapidly seizing the opportunity and are now enthusiastically pressing forward,” according to Steve Merchant, Baker Tilly’s Head of Asset Based Lending.

Our Outlook 2012 survey finds that the proportion of businesses expecting to raise funds by ABL has increased since 12 months ago. This is also reflected in the latest industry statistics from trade body the Asset Based Finance Association, which shows that ABL continued its double-digit year-on-year growth in the third quarter of 2011. This has been assisted by moves in bank regulation.

Other challenging factors

In brief:

• Increased costs directly to the business (69%), downturn in demand (63%) and tax complexity and burden (56%) are the top three threats to their businesses in 2012.
• The impact of economic woes in the eurozone and US (55%), consumer confidence (54%) and increasing regulation (53%) are also serious concerns.
• 58% still expect the Comprehensive Spending Review to have a negative impact on them.
• A quarter of business decision makers are unsure what impact an increase in inflation or interest rates would have on their business.

Our Outlook 2012 highlights a number of additional issues concerning businesses operating in the current challenging economic climate.

International threats and opportunities
“Turmoil in both the eurozone and the United States poses a threat to UK businesses, particularly in light of the volume of business UK companies carry out in those geographies,” says Geoff Carton-Kelly, Head of Special Investigations within Baker Tilly’s Restructuring and Recovery practice.

Therefore, he is not surprised this was regarded as a significant threat by 55% of respondents to our survey. Nonetheless, selling into new geographical markets ranked fourth among the top business strategies of respondents. They perceived demand for exports as a significant opportunity for their businesses. “UK industry can leverage relatively weak sterling to boost its overseas sales – as long as those trading abroad have the right products to export and take advantage of our flexible labour market,” adds Geoff.

Government funding cuts
Fifty-eight per cent of respondents to our survey considered that public sector cuts would pose a threat to their businesses in 2012. “There is considerable uncertainty as to how and where public sector cuts will fall and how they will operate,” explains Baker Tilly’s Chairman of Public Sector Group and Head of Not for Profit Advisory, Jim Clifford.

He notes that amid such uncertainty, new forms of funding for public services are emerging. Social finance is developing as an approach, drawing non-traditional finance sources into involvement with charities and social enterprises. This is helped by the development of the shared value concept – which economic sustainability and the creation of social outcomes can exist alongside each other. Many are still concerned, expecting further casualties to add to the non-profits that have already closed. The sound response to this is for further restructurings and mergers and these are likely to become more common during 2012.

Personal insolvency
In 2012, the risk of personal insolvency could well increase, especially among business owners/managers. Many business owners have used their personal assets, such as their savings or their homes, to underpin or guarantee the funding needed for their businesses. As those businesses have suffered from the downturn in the economy, owners have faced increasing personal financial distress.

“Unfortunately, the credit crunch has seen many owner-managed businesses operating in a reduced market and having to reduce their costs,” says Alec Pillmoor, Head of Personal Insolvency at Baker Tilly. He goes on to explain that some managers did not commence their cost-saving quickly enough, so depleting their own resources, and for others the costs of restructuring required additional funding.

“Our fear is that, in 2012, more business owners will find that they are unable to service the personal borrowings that they have taken out to support their companies and as a result may themselves face personal insolvency,” Alec concludes.

Poor consumer confidence
In November 2011, Nationwide Building Society’s Consumer Confidence Index showed a modest pre-Christmas increase after five consecutive monthly declines. Research by GfK NOP, also released in November, showed that consumer confidence stayed close to its lowest level for two and a half years. Lack of consumer confidence came up in our survey as the fifth most influential threat to SME businesses, with over half of respondents expecting to feel its impact.

With the challenging outlook for the year ahead for employment, social benefits, and the costs of food and fuel, along with the wider global economic uncertainty, it is difficult to see what is likely to boost consumer confidence and bring renewed hope to some retailers which are already struggling. Distress on the high street will undoubtedly continue to dominate the headlines in 2012.

Rising costs to business
The latest published data shows inflation beginning to slowly fall, for example, the Office of National Statistics reported that annual consumer prices inflation (CPI) registered at 4.8% for November 2011, down from 5% in October. The retail prices index (RPI) stood at 5.2%, also down 0.2% on the previous month.

The Bank of England’s predictions in November 2011 were that inflation is likely to decline in 2012 from levels seen in 2011. However, high direct costs remain a major issue for many businesses. In our Outlook 2011 survey, a third of respondents were concerned about the rising cost of the goods and services they bought. Our Outlook 2012 research shows that this has more than doubled to 69% of respondents.

Russell Cash, Restructuring and Recovery Partner explains: “Despite recent modest falls in inflation, high operating costs, driven by essential items such as fuel and certain raw materials, are a cash pressure which simply cannot be avoided. Businesses which are already operating on narrow profit margins and whose products may currently be in low demand are unlikely to be able to pass costs down to the end user. As a result of being tightly squeezed at both ends of their supply chain, I fear there will be an increase in businesses becoming insolvent over the next 12 months.”

Pension deficits
Continued instability in the capital markets has caused the value of company pension schemes to fluctuate significantly. For example, the combined pension fund deficits of FTSE 350 companies, on an accounting basis, are reported by Mercer to have increased by a third from £60 billion to £80 billion over the month of November 2011 alone. Bruce Mackay, Head of Covenant Assessment Services at Baker Tilly comments: “The volatile state of scheme deficits, coupled with a potentially growing squeeze on sponsoring employers’ ability to fund those deficits, mean trustees must be super-vigilant in their management of scheme funding risks.”

Tax burden and complexity
Over half of respondents (56%) to Outlook 2012 highlighted tax burden and complexity as a major threat to their business. “The Chancellor restated in the Autumn Statement his intention to reduce corporation tax to 23% by 2014, when it will be the lowest rate in the G7 and one of the lowest in the G20,” says Joe Burnie, Baker Tilly’s Head of Tax. “However, the top rate of income tax remains at 50% and the tax on capital gains up to £10 million via Entrepreneurs Relief stays at 10%.”

With regard to red tape, George Bull, Senior Tax Partner, suggests that HMRC’s introduction of a new regime of record checks and security checks which delay tax refunds will only add to the burden. There is little evidence that the Government is heeding the concerns of business owners in this regard.

Improvements to existing venture capital tax reliefs, including a generous 50% tax relief on investments in very small start-ups under the newly created Seed Enterprise Investment Scheme, demonstrate that this Government is keen to encourage SMEs to raise funds from sources other than the banks.

Turning to international business, the proposed softening of the Controlled Foreign Companies regime, coupled with the additional incentives to encourage research and development and the lower taxes on patent income, should go some way to staunching the haemorrhaging of creative industries from the UK to less heavily taxed overseas jurisdictions.

Retaining and attracting talent
Baker Tilly’s research shows that 47% of respondents believe that a shortage of skills and access to affordable skilled people is a significant threat to business. “The SME arena is starting to see a shortage of certain types of skilled people in the marketplace,” explains Media and Technology Partner, David Blacher. “Although businesses want to remain lean, they accept that they have to be careful in retaining those people that positively contribute to the business.”

Businesses are increasingly turning to Enterprise Management Incentive (EMI) schemes offering share option arrangements to incentivise staff. “We have seen a resurgence in these of late, which makes perfect sense while the values of businesses tend to be lower,” adds David.

Some glimmers of hope

In brief:

• Taking business from failing competitors is expected to present the greatest opportunity for 42% of respondents in 2012.
• The next greatest opportunities are lowering costs and technological development (both 24%), which may explain why developing products and services are also considered a crucial part of business strategy.
• More than 1 in 8 regards demand for exports to new markets (such as Asia and the Middle East) as an opportunity in 2012.

Despite the doom and gloom, there are several opportunities that forward-looking businesses can maximise.

Increasing market share
Stronger businesses with competitive products and astute marketing skills may be well placed to grow their respective market share at the expense of weaker or ailing competitors. At the same time, businesses with the flexibility to add to their product offerings could move into adjacent markets that are underserved by incumbents or where significant players have fallen by the wayside, creating space for newcomers.

Increased activity in distressed M&A has yet to materialise in a major way. “While low interest rates persist, some businesses are struggling on, able to service their debt but with weak balance sheets,” explains Rod Donaldson, Head of M&A and Private Equity.

However, he expects M&A activity to burgeon once the economy starts to pull out of recession and businesses aim to grow their market share, particularly through the acquisition of stricken market rivals.

Technological improvements
Almost half of respondents to Outlook 2012 listed improving internal processes and/or systems as their top business strategy. In addition, a quarter of those polled identified technological development as an opportunity for their businesses. Baker Tilly’s Head of Media and Technology, David Blacher says: “On the operational side, better, faster, more able systems can save time and money, while an increased focus on online promotion, sales and delivery can enable businesses to reach wider markets more quickly and efficiently.”

Smarter controls
Improving basic disciplines and doing the simple things better and more effectively can ensure business survival and its ability to prosper in the future. “Crucially, it is about being able to maximise all opportunities, especially factors that are within the direct control of management,” says Mark Taylor, Baker Tilly’s Head of Process Improvement

Low-cost borrowing
In general, the cost of borrowing looks likely to remain stable at least for the foreseeable future, according to Tony Wright, Restructuring and Recovery Partner. However, while base rates remain the lowest on record, the actual cost of funds to banks is far higher as they are obliged to offer depositors a premium to attract funds. For the average SME borrower, this means loan margins are at historically high levels of at least 3-4% above base, compared to half that in the boom. Similarly, arrangement fees are high and the level of bank funding is far lower than before. This means that corporate liquidity will continue to be under pressure.

Selling in to new markets
Foreign exchange market commentators suggest that the level of sterling will continue to favour British exports into 2012. With this tailwind, UK companies that can hone their products to the specific needs of overseas customers have the opportunity to open up new international markets with competitive prices. This is not to say that global economic conditions will make this an easy task but an opportunity exists for those businesses that can demonstrate the right approach and product offering.