Investing for Growth: Comparison of German and UK Markets

Mid-sized companies are often called the ‘engine room’ of any country’s economy. The agreed definition of mid-sized businesses across Europe are those either with 50-249 employees, or €10-50m turnover¹. The mid-sized business community is a particularly high consumer of working capital finance; and in view of this, plus their relatively low profit margins, mid-sized companies are particularly vulnerable to economic downturns. A small dip in sales volumes can seriously affect their margins of profit. Therefore, their overall attitude to growth, business investment and debt provides a sensitive indicator of a national business community’s current sentiment and, by association, its likely commercial development in the near term.

In order to gauge the current behaviour and attitude to business development of such mid-sized companies, Siemens Financial Services conducted a research study among a representative sample of 7,500 firms in the UK and Germany (see methodology at end of article). This study examined the cost of interest payments in relation to profits for mid-sized companies and large companies in both countries, across the financial years ending 2003, 2004 and 2005. The study also looked at how much cash companies were holding at the end of each of these financial years, as well as their profitability.

The study of trends in interest payments – or the cost of borrowing – is significant in that this entry in a company’s profit and loss accounts includes both traditional financing (e.g. bank borrowing and fixed interest instruments) as well as the larger proportion of alternative financing (e.g. leasing and asset-based finance). It therefore provides a good measure of the overall financial pressure that a company is shouldering.

The interpretation of trends in this measurement of financial pressure can be taken in one of two ways. High rates of interest payments, relative to profits, could indicate a burden of borrowing that is difficult for the company to bear, and should therefore be taken as a negative indicator. At the same time, if the company has high reported profits and accumulated substantial cash reserves, but is also making interest payments that are high relative to profits, then the company might be considered to be raising working capital it can easily afford in order to accelerate growth – a positive indicator.

For this reason, the study looked at the burden of interest payments alongside pre-tax profitability and the end-of-year cash position. Therefore, there are two significant outputs from the results: how heavy is the burden of borrowing and where are mid-sized companies choosing to obtain their working capital?

In the study’s comparison of mid-sized and larger companies in the UK and Germany, two very different attitudes emerge.

Cost of Borrowing Rises for Lower Rated Companies

Source: Ernst & Young 2005

The Statistics

German mid-sized companies’ interest payments in 2005 averaged just 25 per cent of the amount of their pre-tax profits, a much more conservative position compared to British mid-sized firms who made interest payments equivalent to 56 per cent of their pre-tax profit margin. In parallel, however, German Mittelstand companies only built up cash reserves in 2005 to just under 3 per cent of the size of their turnover. This contrasts starkly with British medium-sized firms who, by FYE 2005, had built average cash reserves equivalent to almost 16 per cent of turnover.

British firms have been the beneficiaries of robust profitability after the millennial stock market and economic downturn, supported by sustained consumer and public sector spending and therefore avoiding recession. In 2005, UK mid-sized companies delivered pre-tax profits at an average 5.24 per cent of sales, whereas their German counterparts were making less than half that figure, at 2.5 per cent of turnover.

Study Findings – Germany

German Mittelstand companies have dramatically reduced their real burden of borrowing. From a position in 2003 where Mittelstand companies were paying out interest sums that were almost two-thirds the size of the amount they were making in pre-tax profits, they have now reined in their interest payments to just a quarter of the size of their profits. Given that these mid-sized companies are also reporting relatively low profits, yet knowing that equipment investment is rising, we might infer that they are ploughing a proportion of any ongoing surplus back into the business.

In addition, the cash reserves that German Mittelstand companies have built up are much smaller – when compared to turnover – than those of British mid-sized companies. This would indicate that although their achievement in reducing borrowings is dramatic (perhaps even more dramatic than immediately appears from the figures), profitability has some way to go to replicate the high-profit, high leverage, high-cash situation in British mid-sized companies. The choice of whether or not to generate high cash reserves to combat tactical circumstances is an issue that will be discussed later in this article.

A number of factors need to be taken into account when comparing the accounts of German and British mid-sized companies. Levels of timely annual financial reporting are lower in Germany than in the UK, slightly (but not significantly) affecting the study’s medium-sized company sample size for Germany. In recent years, German banks have introduced mezzanine financing products for Mittelstand companies² which, because they convert debt to equity in certain circumstances, might be expected to slightly suppress the burden of interest payments. On the other hand, counterbalancing factors tend to smooth out any effect from these considerations.

Access to capital in eurozone countries, such as Germany, is less expensive than in the UK because the difference in base interbank lending rates (EURIBOR versus LIBOR). Moreover, we know from the latest European Central Bank reports that lending criteria in continental Europe are easing, not tightening³. Many commentators have pointed to the removal of state backstop guarantees for Germany’s Landesbanks as being a potential suppressor of credit availability for the Mittelstand. However, the guarantees on existing loans continue through to the end of the decade, and so cannot be attributed with any significant effect on credit availability at this stage.

In fact, the availability of liquidity did not dramatically reduce over the last five years, but the trend among German banks towards risk-based pricing of loans made that traditional source of liquidity unattractive to many German companies with lower credit ratings. One bank’s 2005 annual report shows that while its Mittelstand lending volumes had hardly moved at all since the previous year, its margin on that business had tripled and its loan-loss provision had fallen by a third⁴. Such results point to a polarisation of commercial lending where those with a less than ideal credit rating have been priced out of the market.

Commentators are now arguing, with hindsight, that falling commercial loan volumes among mid-sized companies had as much to do with falling demand as it did with rising prices⁵. It is now recognised that several years of low profitability had created a lack of business confidence, which in turn lead to investment deferral. In addition, the KfW Bankengruppe (KfW) also remarked in a recent paper on the ‘more demanding requirements of business transparency’ required by lenders. Willingness and ability to provide such transparency from mid-sized firms may also be a suppressant of credit usage.

One distinct possibility is that German mid-sized firms are reinvesting profits during the year rather than emulating British behaviour of raising bank loans for investment and reporting higher profits. This would go some way towards explaining the lower reported profit levels among German mid-sized firms compared with their British counterparts. Again KfW has remarked upon the SME financing culture, saying that, ‘SME financing in Germany is based traditionally on two pillars – internal financing from retained earnings and depreciation, and bank loans’.

This conservative, debt-averse attitude would tend to echo the continuing uncertain economic environment in Germany, where an export-led recovery is definitely taking place, but consumer spending is still relatively weak, falling in the past three months of 2005 for the fourth consecutive quarter. This study’s figures showing pre-tax profit as a proportion of total sales, reveals that reported German profitability – especially in the Mittelstand – remains somewhat behind its UK equivalent.

Despite German mid-sized companies’ lack of cash reserve building, they are still making some investment in growth, but using alternative finance with which to fund that investment. In fact, use of leasing across all assets, e.g. equipment, motor and buildings, in Germany, at 17 per cent of gross fixed capital formation, lags the UK, where the equivalent percentage is 24.5 per cent⁶. On the other hand, the Ifo (Information and Forschung) Institute’s most recent leasing sector survey⁷, published at the end of 2005, shows that equipment leasing is growing dramatically in Germany. The Institute reports an estimated rise in equipment leasing in 2005 of almost 9 per cent. Leasing’s share of total equipment investments now stands at 24.1 per cent and is expected to rise to 24.6 per cent by the end of the year.

Finally, there is a growing expectation that capital investment in mid-sized German companies is soon to surge; the result of several years of restraint and concentration on ‘replacement only’ investments⁸. However, rising confidence in the economy – a necessary precursor to major growth investment decisions – is likely to outstrip both the availability of self-generated capital, and the mindset change towards the transparency required to establish a good credit rating with a bank. Asset-based finance is therefore likely to be more popular among German mid-sized firms as the financing technique of choice to fund the long-overdue upturn in technology and equipment investment.

Study Findings – UK

In the UK, both the cost of interest payments, and the use of finance (relative to profits) is higher than in Germany. This difference is too large to put down to differing base lending rates in the two countries.

British mid-sized firms appear to be doing two things: taking on more debt in order to fund business investment in growth; yet at the same time building up relatively large cash reserves for tactical, rapid-access liquidity.

Many industries where mid-sized firms dominate, such as retail, printing, motor, information and communications technology (ICT), are reporting a trend of consolidation and acquisition. Healthy firms are making good profits, and less healthy ones are encountering intractable business difficulties. The natural consequence is that the strong acquire the weak. This could be one factor that explains the higher use of credit, and indeed the building of cash reserves for tactical activities. In very volatile and highly competitive markets, quick-reaction tactics – whether pricing changes, marketing campaigns or sales force investment – require immediately available working capital.

As in Germany, though, alternative finance is also growing among UK mid-sized firms. A survey from the Forum for Private Business⁹ reports that for investments between £25,000 (€40,000) and £100,000 (€160,000), asset finance was the preferred financing option used by just over half of SMEs. Siemens Financial Services’ own research¹⁰ has reported a swing from traditional bank lending to asset-based finance, such as leasing, hire-purchase and tech-refresh packages.

UK mid-sized firms are being both bold and cautious at the same time. The lessons learned just after the millennium, when business volumes reduced, liquidity tightened and available cash was scarce to deal with tactical competitive challenges, have been taken to heart, and these medium-sized enterprises that found themselves squeezed between a slow market and demanding large company customers or fierce large company competitors are now conserving a cash war chest as a competitive insurance policy. At the same time, UK mid-sized firms are also taking advantage of the lines of liquidity they can access – increasingly alternative finance – to make investments in the equipment and facilities they need to improve their competitive position.

Medium-sized Companies – Alternative Finance

Lease finance is likely to be a major beneficiary of the swing away from relationship lending. The attractions of leasing are not simply tapping into additional lines of credit, but also cash flow friendly finance, as well as the flexibility of being able to upgrade equipment during the term of the lease. Terms are fixed at the beginning of the lease, so provide for dependable financial planning, cushioned from market or economic volatility. A greater proportion of firms in the UK, Italy and Ireland already obtain finance via leasing than from bank loans¹¹. Other countries have more ground to make up in the use of alternative financing relative to bank borrowing. Overall, the story is one of gradual, but inexorable take-up of the leasing option. Moreover, there is some considerable growth yet to come as European countries progress towards US leasing penetration levels in the region of 30 per cent.

Conclusion

The study revealed very different approaches between German and British mid-sized firms towards investing for growth and the ways in which that investment is financed.

German firms are still taking a conservative attitude towards raising finance as the economy improves at a gradual pace. They have moved substantially away from traditional bank borrowing, and towards alternative financing arrangements where, for instance, asset-based financing, such as leasing, hire-purchase and tech-refresh, is seeing considerable growth. Many lower-rated mid-sized German firms are ploughing a proportion of profits straight back into the business, rather than take on traditional debt.

British firms, the beneficiaries of post-millennial years in which consumer and business-to-business spending held up well, are taking a much more ‘bullish’ approach, taking on traditional and alternative financing to a very high level compared with their profits. Nonetheless, and perhaps because of an awareness of how lucky the British economy was to escape recession after the millennium, the British mid-sized firm is also showing a cautious streak as well, hanging on to very substantial cash reserves at the same time as raising large amounts of finance to fund growth investments.

¹ European Commission, Recommendation 2003/361/EC
² For instance, see the Finanzplatz Munchen Initiative.
³ European Central Bank, Euro Area Bank Lending Survey, January 2006
⁴ Commerzbank, Financial Statement 2005
⁵ Dr. Hans-Joachim Massenberg, Bundesverband Deutscher Banken, Mittelstandsfinanzierung February 2005
⁶ Lease Europe
⁷ Ifo Institute, Business Survey in Leasing, December 2005
⁸ Dr. Hans-Joachim Massenberg, Bundesverband Deutscher Banken, Mittelstandsfinanzierung February 2005.
⁹ Forum for Private Business and Finance and Leasing Association, SMEs and Capital Investment, November 2005
¹⁰ Siemens Financial Services, Technology Takes Off, June 2005
¹¹ Grant Thornton, European Business Survey 2001

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