Return on Capital: a snapshot of British Business

Whenever you are investigating a firm’s accounts – perhaps using ratio analysis – you quickly realise that the answers you’re generating only really make sense when you compare them against something, like last year’s figures, or those of a rival.My students are looking at a case study (OCR F297) in which a firm is making a return on capital of approximately 11%. We were wondering if that was a ‘good’ return or not. I’ve come across an article that directly answers that question, and raises some other points that offer a revealing insight into the health of Britain’s businesses.

The Economist article says that the overall return on capital was 11.5% in the first quarter of 2013, close to its long-run average. It picks up on examples of several firms who are doing exceptionally well, adding further evidence to the argument that a good business can thrive even under current conditions. Yet a growing number of firms are struggling. A study of profitability across a range of firms reveals that of the top 10,000 firms, close to 20% made a loss in their most recent year, up from 15% in 2005. Temporary losses are not always a problem: developing new products can mean high costs today and big profits tomorrow.

But for many firms losing money is becoming a habit. Of the loss makers in 2011, only 43% were in the black in 2012. Before 2007 the rebound rate was close to 55%. Many firms are being kept alive by a combination of generous treatment by banks and an abundance of cheap, willing labour. These are sometimes called ‘zombie’ companies, who stay on life support propped up by ultra-low interest rates.

There may be worse to come. Public limited companies make careful profit forecasts and the number of firms issuing market warnings rose in the second half of 2012. That trend looks likely to continue. And the overall average figures disguise big variations between sectors. Whereas the payoff to selling services returns is holding steady, the returns to investors in manufacturing have slumped.

Despite far more firms being underwater than in the early 1990s, failures are surprisingly rare. But now the sheer number of these weak firms means that a pickup in the bankruptcy rate might start to begin. The article finishes by arguing that perhaps the best hope is that the availability of large cheap loans enables healthy companies to buy out the poor performers. A merger wave would be welcome; it would shake out Britain’s loss makers while minimising the pain for workers and banks.