Thursday, 15 October 2009

The Economics of Debt

Any small businessman will tell you that debt is a huge burden. It is not only that the interest cost is a drain on money that can otherwise be invested but it is the notion that once you have a debt, it is damn difficult to get rid of it.

Other businessmen think debt is fantastic. From it you can leverage huge profits and it is the principle behind many private equity fuelled buy outs. For a small capital outlay, vast sums of money can be borrowed to buy companies which can be later sold with a disproportionate amount of profit from the risk going to the private equity house. In the purchase of Boots, private equity outlayed less than a few hundred million while raising £9bn.

Debt, in that sense is good. Philip Green used a pile of debt to pay himself a one-off dividend of £1bn tax free. Debt, in plenty of senses then, is good.

But for the average business, the problem with debt is that it has to be productive in terms of increasing profits. Without a huge boost to profits, cashflow does not sustain the interest payments and so you have to borrow more in the hope that your business will catch up. In the end, it can be good money after bad as the implosion inevitably comes as the debt gets ahead of the business. For small businesses, debt is only good for working capital and generating more cash, beyond that it is a millstone.

So how do Government's view all this? The US just closed out its fiscal year with $1.4 trillion of debt, the highest national debt since 1945. As former Head of the Fed, Alan Greenspan, observed this is the most worrying aspect of the US economy. The equations start getting explosive in his eyes as more money is required to pay interest on the debt and you end up borrowing more just to pay the interest - the priority has to be to bring that debt down.

There are a few ways to do this. First up, you can get the economy growing, which is why there is so much debt there at the moment as the US tries to use more debt to stimulate the economy. This is exactly Greenspan's issue - using debt to stimulate growth can go horribly wrong and it's exactly what small businesses fear - if the revenue streams do not come through fast enough to bring much needed cash, then pretty soon you end up borrowing more. The second way, is to sell assets which has been the recent domain of the UK Government. The problem is that beyond gold, countries usually do not have easily 'liquifiable' assets. In Britain's case, we no longer have large golden stakes in large companies, we have the stakes in the banks but they are all still under water while other things like buildings and debts are not so easily sold. One thing we did not have was gold to sell. Such asset sales, as a small businessman would know, tend not to add much to the coffers to reduce debt - in our case it may be a few company cars, maybe a building, furniture or plant facilities. Asset sales of this type are usually done in desperation, like pawning jewellery in the face of credit card debt. Inevitably you are a buyer's dream and so you will never get full value for your assets as the British Government will soon find out.

Further, selling assets as a business means you have less to bargain with for the future and for a Government, once it is sold that's it - gone. The final way to make inroads into debt is to make cuts in the budget. Small businesses know all about this. Wastage is the first port of call but usually there is not a massive amount of 'wiggle room'. Certainly, the end of month pizzas may go, fresh flowers in reception, travel is fairly game forcing salespeople and managers to think hard before travelling and then looking levels of spend on things like flights and hotels. Then it gets nasty - the biggest expense for small business is the salary bill and that's where cutting can produce real savings. Of course, you are affecting your future capabilities but needs as must - for my money, it should always be the last port of call.

And so to Government. I argued yesterday that cuts can be made very easily - when you look around at the multifarious layers of Government and the associated lackies and cost, long before you start affecting public-facing services, you have vast layers of expense which are pure wastage. This is an easy starting point for Government and savings can be realised very quickly by canning external advisers, consultants, halting project overruns, getting rid of contractors, looking at layers of management and getting rid of many of them.

It has been pointed out that this recession has been felt almost exclusively in the private sector and that the public sector has done nothing to rein in cost, eliminate wastage or make cuts. Thus, the majority of the newly unemployed have come from the private sector. Yesterday, we saw positive results on the unemployment number as the rate of additions to the total seemed to slow and this had a small positive effect on the budget deficit forecast for the month. This could be a false dawn as the Government are going to have to start making some serious cuts - very soon and that means people hitting the dole queues from the public sector. It's crazy that it hasn't yet happened - but it has to.

My point in all this is that as small business people we know the economics of debt. It is a bad thing, particularly when markets are depressed. You can borrow in such times but it is usually out of desperation when in all reality, you should be cutting your cloth. Spending money in the hope things will come good, without a great plan for finding ways to grow, usually ends in tears as interest payments mount.

Alan Greenspan knows a thing or two about economics and I think he is right. Debt is know reaching the critical point - Britain is spending in the hope of an upturn and spending big. While you have to spend money to stimulate, you have to realise that in the background you have to make essential cuts.

It isn't as if we cannot survive if cuts are made - Britain is a bureaucratic monster with one of the heaviest public sectors in Europe. If we cannot find efficiencies in this structure then we ought not to be in Government, because as small businessmen we can see it all too easily.

The public sector is too big, too fat, has overly generous pension schemes and is a huge burden on our taxes and business - it has grown vast, inefficient, multi-level departments, which are mini-governments in themselves, over the last 12 years that has spawned regulation after regulation culminating in the last tranche of the farcical new Companies Act just last month which was years in the making, issued in 3 almighty sections and added really just 4 things of note to over 97% of the number of companies in Britain.

The waste is just awesome and shameful - and it needs to be cut, and fast.

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