Adapting in tough times the growing resilience of UK SMEs

About this reportIn November 2012, the Economist Intelligence Unit, on behalf of Zurich, surveyed 549 small business owners and directors in the UK to explore what SMEs think about the c

Adapting in tough times: The growing resilience of

UK SMEs

Written by

About this report

In November 2012, the Economist Intelligence Unit, on behalf of Zurich, surveyed 549 small business owners and directors in the UK to explore what SMEs think about the current economic landscape and how they are adapting in order to survive and succeed

In addition, in-depth interviews were conducted with two SME experts Our thanks are due to the following for their time and insight:

Mike Cherry, the National Policy Chairman at the Federation of Small Businesses.

Professor Stephen Roper, Director of the Enterprise Research Centre at the University of Warwick

The report was written by Melissa Carson and edited by Monica Woodley of the Economist Intelligence Unit

Contents

The past five years since the financial crisis have presented perhaps the most challenging economic times since the Great Depression and Second World War The recent World Economic Forum (WEF) Global Risk report1 highlighted economic fragility and resilience as the principal challenge for individuals, businesses and government today It is no surprise then that the UK small business – whether a sole trader, start-up manufacturer, local pub

or hair and beauty salon – has been under constant financial pressure

This report, Adapting in Tough Times: the growing resilience of UK SMEs, developed

in association with the Economist Intelligence Unit (EIU), looks at the general state of fragility within the UK SME sector after five years of challenging economic times; how

UK small-medium size enterprises are responding; and what risks are emerging as a result, both for the small business and the larger SME economy

The good news is that our research demonstrates there are green shoots of recovery already underway Indeed, many SMEs in the UK are more fit for purpose and in better shape to manage risk and volatility in the future The long-term nature of this economic crisis has forced SMEs to adapt to the environment And perhaps the most crucial adaptation is a newfound appreciation for risk; this is a fundamental change in SME business mindset and management behaviour

UK small businesses are investing and diversifying, building a platform for competitive advantage and resilience in the long-term Many are moving to a more variable cost business model, providing financial flexibility during times of volatility, tight margins and rising operating costs

However, our research with EIU also highlights the macro-economic risk of a ‘two-tier SME economy’ emerging in the UK Whilst many SMEs are adapting, the ongoing financial pressure is eroding the competitive health and vitality of a significant number

of small businesses – potentially introducing a turnover gap between ‘winners’ and

‘losers’ in the long-term

‘Recovery’ and risk, both at the firm and SME economy level, is foremost on the minds of sole traders and small businesses, independent advisers, economists and institutions alike

Indeed, given the broader market context, risk for SMEs is only becoming more complex

We hope this report will provide further insight into the complex risk dynamics now underway within the UK economy – and help the insurance industry and other stakeholders support a return to stability and growth for SMEs

Richard Coleman

Director, SME

UK General Insurance Zurich Insurance plc

Foreword

1 Global Risks 2013, World Economic Forum (WEF)

Executive summary

The past five years of economic stagnation and volatility have forced UK small and medium-sized enterprises (SMEs) to undertake the most significant adaptation and shift

in management behaviour in decades

SMEs have become stronger through diversification and deleveraging, in addition to more operationally resilient and better prepared to manage economic challenges and the new risk landscape But they are also more cautious and risk-averse across the board compared with five years ago, raising concerns that SMEs will not be the engine of economic growth that drags the UK back from the brink of a triple-dip recession The economy may never return to the level of stability experienced in the decade prior

to the 2008-09 global financial crisis Although SMEs are better prepared to manage this new economic reality, they are still struggling as operating-cost fundamentals are squeezing business margins In particular, low-performing businesses appear to be undercutting themselves by taking a short-term approach, increasing the risk to business survival in the long term There are indications that their Achilles heel might be whether they fully appreciate the long-term market dynamics at hand, and ongoing economic stagnation remains the greatest threat

In general, SMEs seem cautiously optimistic about the future In a survey of over 500 UK SMEs conducted by the Economist Intelligence Unit, three-quarters of respondents feel that their company’s position is financially secure – and many for good reason SMEs have undertaken the biggest management-behaviour shift in a generation – adopting a more strategic approach to risk and taking a longer-term view on financial planning, debt, business continuity preparation and building reserves The more secure high-performers have been implementing resilience measures such as adapting financial and operational business practices – a lesson from which their low-performing peers must learn Indeed,

a growing and divergent turnover gap between the ‘winners and losers’ may indicate a second economic challenge for low-performers beyond that of stagnation – increasing market competition leading to natural selection within the SME economy

Experts agree with the picture painted by the survey that SMEs are also much more cautious across the board than was typical of small businesses five years ago, whether consciously

or not Their risk appetite, for example, is no greater today than it was two years ago, as many have been waiting for an economic recovery before returning to ‘business as usual’ – considering re-investment in the business, for example However, given the continued economic stagnation, SMEs have put risk-taking and opportunism on hold

The dual issues of a ‘winners and losers’ dichotomy and a conservative, risk-averse business mindset present significant potential challenges to the short-term prospects for SMEs and the broader UK economy

How are UK SMEs adapting to tough times?

Business threats

High-performing SMEs

Low-performing SMEs

59% of SMEs feel confi dent in the outlook for their business and they have performed better than their less confi dent peers on a range of measures over the past two years

They have made strategic, long-term

adaptations to their businesses such as:

53% Diversifi cation of products and services

48% Improved productivity

52% of SMEs now spend more time thinking about their business strategy

But SMEs have also adopted a conservative mindset 25% rate themselves as risk averse

This raises tough questions about the short-term prospects and long-term strength

UK’s SME economy – and thus the UK economy as a whole

In contrast, low performers have made tactical,

short-term changes such as:

What was the greatest threat to your

business two years ago? TOP 5 What is the greatest your business today threat to

?

2 YEARS AGO TODAY

Weak demand due to economic stagnation 44% 52%

37%

Reducing p

rices for custome

rs

51% Working longer hours

adaptations

53%

48%

TOP

5

Source: Economist Intelligence Unit

The impact of stagnation on UK SME survival

Table 1: Threats

What was the greatest threat to your business ?

2 years ago Today Change

Weak demand due to economic stagnation (a lack

of economic growth)

44% 52% Increased

Operational cost challenge (eg sudden rise in energy costs;

high fixed costs)

25% 37% Increased

Inadequate cash reserves 31% 27% Decreased Poor access to finance 16% 21% Increased Failure to manage cash flow (working

capital)

22% 17% Decreased

Supply chain or logistics failure (eg key supplier failure;

loss of contract or poor inventory management)

15% 14% Static

Non-compliant business practices (eg data loss; sanctions; tax)

12% 12% Static Over indebtedness 19% 11% Decreased Uninsured major loss event

(eg fire, flood)

9% 8% Static Other (please specify) 5% 7% n/a

UK SMEs operate in a high-risk environment Threats from all sides – the market, operating environment and finances – are squeezing them while the risk environment appears relentlessly unstable In the short term, this raises questions about the viability

of the SME sector to instigate economic growth

The greatest threats to SMEs are economic stagnation, operating-cost volatility (such

as energy costs) and inadequate cash reserves These, among other related and interconnected pressures, mean that SMEs are stretched to their limits In this section

we look at each of these threats in detail and the implications for SMEs

Long-term economic stagnation

Economic stagnation is currently the greatest threat to SMEs, according to over one-half (52%) of survey respondents, representing an increase from 44% two years ago “While aspirations are high,” notes Mike Cherry, the National Policy Chairman at the Federation

of Small Businesses (FSB), “there is a lack of confidence in the general economy that is holding [SMEs] back.”

With prolonged economic stagnation, adds Professor Stephen Roper, Director of the Enterprise Research Centre at the University of Warwick: “There is an attrition effect SMEs inevitably get worn down, not just their resources but also morale This psychological effect is very important for some Even if you feel your business is resilient,

it is at this point you ask yourself if you have the drive to invest in the future.”

Mike Cherry is the National Policy

Chairman for the Federation of Small

Businesses and leads the policy team in

Westminster, Whitehall and Brussels.

Stephen Roper is Director of the

Enterprise Research Centre, an

independent research centre which

conducts policy relevant research on SME

growth and development, and Professor

of Enterprise at Warwick Business School.

Source: Economist Intelligence Unit

The impact of

stagnation on

UK SME survival

Table 2: Top three threats today by Industry

What was the greatest threat to your business ?

Weak demand due to economic stagnation (a lack of economic growth)

Operational cost challenge (eg sudden rise

in energy costs;

high fixed costs)

Inadequate cash reserves

Building and construction services 43% 50% 36%

Manufacturing 38% 42% 36%

Media, marketing or entertainment 54% 33% 24%

Other consumer or business services 53% 35% 31%

Professional or financial services 63% 31% 19%

Property management and rental 28% 32% 32%

Retailing and distribution 50% 32% 37%

There are some industries that are more resistant to long-term economic stagnation

Professional and financial services rate this as their top threat, as their business-to-business transactions mean that they depend on the ability of other businesses to pay By contrast, property management and rental agencies are less exposed as their business is a necessary requirement for both consumers and other businesses

Stagnation is also inducing a fundamental shift in the SME business-risk mindset Mr Cherry says: “While SMEs are more able to take a more realistic approach than they were previously they are very aware of the economic crisis and risk environment and now (as a result) they are more cautious.” Greater caution among SMEs will be discussed further in this report

Rising business operating costs

Operating-cost challenges have increased significantly in the past two years – and have been the most difficult financial metric for SMEs to manage Over one-third (37%) of those surveyed see these challenges as one of the greatest threats to their business, up from 25% two years ago

Better-performing SMEs – as we will see later in this report – have not managed this challenge any better than their lower-performing counterparts, in a reflection of operating-cost dynamics, such as rising energy costs, rents and logistics

The industries most concerned about operating costs are building and construction (50%) and manufacturing (42%), which is not surprising given (for example) the energy requirements in these industries Information Technology (IT) services is the industry least concerned (26%) among those surveyed

Source: Economist Intelligence Unit

Dwindling cash reserves

Insufficient cash reserves are a major constraint on SMEs, as increasing financial resilience

is critical to withstanding unanticipated risks, long-term stagnation and, perhaps most importantly, a return to economic growth “We have seen many large companies building huge cash piles over the past few years,” says Professor Roper, “allowing them

to build some comfort margin into the business But this is just not possible for many cash-constrained SMEs.”

Although SMEs are slightly less concerned today about the level of their cash reserves – 27% are worried at present, compared with 31% two years ago – Mr Cherry wonders

if SMEs really appreciate the cost burdens that they face The declining concern over reserves does not fully align with expert views

Professor Roper notes: “One of the most difficult times for small companies is when the economy is emerging from a recession Often this is because they have burned through their cash, their liquidity is limited and they want to start to think about expanding (with few reserves to fall back on).” For those SMEs that have not faced this challenge before, the scale of the challenge may not be as apparent as to the experts

The attritional impact

Almost one in five UK SMEs overall (18%) have considered closing down their companies

in the past 12 months, reflecting the realities of being a small business (35% of SMEs in the UK do not make it past three years of trading1) Although this is no consolation for the roughly 863,000 businesses that will fail, the durability of enterprises today does not appear to be poor against the backdrop of the high-risk environment

1 ’Success in challenging times: Key lessons for UK SMEs’, published by Kingston Smith and the Surrey Business School, University of Surrey, 2012.

The impact of

stagnation on

UK SME survival

I have considered closing down my business in the past 12 months (3)

The risk of my business failing has increased in the past 12 months (4)

Table 3: Risk environment: Do you agree or disagree with the following statements?

Agree 18%

Agree 32%

Neutral 10%

Neutral 8%

Disagree 72%

Disagree 60%

Source: Economist Intelligence Unit

The risk environment, however, continues to worsen for a significant proportion of SMEs

On average, one-third (32%) of those surveyed feel that the risk of their businesses failing has increased in the past 12 months, and in many industries it is significantly worse

Automotive trades and transport, as well as hotels and restaurants, are facing the toughest conditions, with 57% and 46% respectively reporting an increased risk to business failing in the past 12 months For example, over the past year or so the negative impact on road freight has been exacerbated by significant weather disruptions during the winter of 2011, while the customer base of hotels and restaurants is being affected directly by economic stagnation

On the other end of the scale, property management and rental, as well as professional and financial services, have experienced a more stable risk environment, with only 24%

and 27% respectively reporting an increased risk to business failing over the same period

Table 4: Risk environment by industry

The risk of my business failing has increased in the past 12 months?

Industry Yes No Don’t know Respondents% Note*

Motor trades and transportation 57% 44% 0% 4% indicative Hotels, restaurants, cafes and pubs 46% 50% 5% 4% indicative Media, marketing or entertainment 37% 59% 4% 8% representative Retailing and distribution 37% 53% 10% 11% representative Building and construction services 36% 57% 7% 5% representative

IT services 33% 54% 14% 8% representative Manufacturing 30% 62% 8% 9% representative Child or pet care 30% 60% 10% 2% indicative Other consumer or business services 29% 59% 12% 9% representative Not-for-profit organisation 27% 64% 9% 2% indicative Professional or financial services 27% 65% 8% 29% representative Property management and rental 24% 72% 4% 5% representative Healthcare or related services 22% 61% 17% 3% indicative

*Indicates whether the sample size is representative or indicative of a given industry sector based on sample size in our survey

The impact of

stagnation on

UK SME survival

Source: Economist Intelligence Unit

Economic risks are squeezing UK SMEs over time

The squeeze on UK SMEs can be seen concretely in their financial performance Over 85%

of SMEs have seen shrinking or flat profit margins, cash flows, reserves and investments

in the past two years Furthermore, margins and operating costs have been most difficult

to manage owing to external factors such as higher energy costs, anaemic growth in the UK economy, the eurozone crisis, consumers’ focus on price and the growing shift towards online channels, among others Business operating costs is the one area where all UK SMEs have struggled

Overall, the survey presents a bleak picture of challenging times experienced in the past two years, and although some metrics, such as debt, have been better managed (see next chapter), SMEs are stretched to their limits in this prolonged environment of elevated risk

Table 5: Financial performance

What has happened to the following financial metrics at your firm over the past two years?

Positive movement Stable

Negative movement

Difference: positive – negative movement

Business operating costs (7) Positive (Shrinking)/

Negative (Growing) 10% 52% 38% -28% Profit margin (3) Positive (Growing)/

Negative (Shrinking) 15% 47% 39% -24% Reserves/savings (6) Positive (Growing)/ Negative (Shrinking) 10% 58% 32% -22% Cash flow/working capital (1) Positive (Growing)/ Negative (Shrinking) 13% 53% 34% -21% Investment (2) Positive (Growing)/

Negative (Shrinking) 11% 59% 30% -19% Turnover (4) Positive (Growing)/ Negative (Shrinking) 27% 42% 31% -4% Debt (5) Positive (Shrinking)/ Negative (Growing) 28% 62% 10% 18%

The impact of

stagnation on

UK SME survival

Source: Economist Intelligence Unit