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Financial planning

Have underwriters lost the confidence to override credit decisions made by a computer?

There has been a plethora of company failures, profit warnings and strategic shortcomings reported in the financial press over the past few months. Many who have read these articles will have thought to themselves that hindsight is a wonderful thing. Hindsight does allow analysts to comment with authority.

The challenging aspect of credit assessment is that it is forward-looking and does not benefit from hindsight. Clarks Shoes has been in the financial news recently with commentary around falling profits and a resetting of corporate strategy. Once again, the news has broken, and we can apply the benefit of hindsight. The question that intrigues us is – ‘what analysis did the underwriters perform prior to agreeing or renewing the debt facilities at the beginning of the financial year’?

Of course, we will never know the answer to that question, but we can make an educated guess. We have reviewed the financial statements for C&J Clarks for the financial years ended January 2018 and 2019 and tried to put ourselves in the shoes of an underwriter. We have not, for the purposes of this short article, drawn upon the Chairman’s or Chief Executive’s commentary.

The financial statements of 2018 confirm:

  • Sales fell by 6.9% to £1,539m
  • Operating profit fell 29% to £29m
  • After interest payable and taxation, the profit of £6.5m in 2017 became a loss of £(31)m in 2018
  • Cash available for debt servicing is around £97m, and long-term debt is £157m.

The financial statements for 2019 confirm what we have learned from the financial press:

  • Sales fall by another 7%
  • Operating profit of £29m converts to a loss of £(75)m
  • Cash available for debt servicing falls to £23m while long term debt is now £55m
  • Cash deposits have been used to pay down debt

It is very difficult for an underwriter, when performing an annual review or refinancing assessment, to forecast with certainty, that profit and cash flow will melt away and predict potential default. In the specific case of C&J Clark Ltd, the signs were there in 2018, sales and profits were reducing, after-tax the business was loss-making.

We suspect that if we review the financial statements for De La Rue, Topps Tiles, Mothercare and Thomas Cook, we would arrive at the same conclusion – the warning signs are evident. These warning signs should be the building blocks for a constructive and probing discussion with the management team about the business’ future performance. I think that this is the crux of the matter. Following the ‘credit crunch’ and the financial crisis, the Financial Services sector has lost many experienced underwriters. Those underwriting positions have been filled by new entrants into the financial services sector post-2008. These new entrants have not lived and worked through a recession, currency crisis or numerous business failures. The continuance of the low-interest-rate policy appears to be the norm. It is difficult to envisage the impact of an increase in base rate to say 2% or 3%.

The same argument could be applied to the management teams of some businesses. These management teams are also young and have not operated through a recession or overseen a business turnaround.

We need to push underwriters up the experience curve. With the benefit of inherited experience, underwriters will be able to pose probing questions of management teams and challenge the key assumptions that drive forecasts of future performance. Lack of experience may result in large corporate business brushing-off the underwriter’s enquiries or the manager of an SME receiving funding for a business project that will not deliver acceptable returns.

We began talking about a plethora of company failures, profit warnings and strategic shortcomings. These will always occur; there is so much that we cannot predict or anticipate. However, if we can provide the underwriting community with inherited experience, we may reduce the number of surprises and hindsight articles.

Author: Bill Liddell, Director.

#Credit Asssessment #Credit Skills #Credit Training #Digital Banking #Management Assessment

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