The Art of Business Survival
The economic recovery following the pandemic initially boosted business profits, but recent challenges have emerged due to rising input costs, higher interest rates, and a slowdown in demand.
Most industries have managed to maintain similar profit margins to what they had before the pandemic, except for the accommodation and food sector, which has experienced a slight decline.
Smaller businesses, especially those with loans tied to variable interest rates, have faced significant increases in their interest expenses due to the rise in interest rates. In contrast, larger publicly traded companies have used strategies like interest rate hedges to mitigate the impact of higher rates on their finances.
Despite some businesses tapping into their cash reserves to navigate these challenges, overall cash reserves have grown over the past two decades, with a significant increase during the pandemic. Many publicly listed companies still maintain substantial cash reserves, and a majority of them can cover their short-term financial obligations, even if they are not making a profit, mainly because they have limited debt.
The number of company insolvencies in Australia has risen to levels seen before the COVID-19 pandemic. While most of these insolvencies involve small companies, there has been an increase in medium and large businesses facing insolvency. This is a concern because larger businesses have more employees, larger debts, and extensive connections with other companies through trade credit, which can transmit financial stress. The construction industry has seen a significant uptick in insolvencies, accounting for a third of the recent increase, though these levels remain relatively low compared to the pandemic period.
Despite the increase in insolvencies, the direct risks to the banking sector are limited, as banks have relatively low exposure to these troubled companies. Most insolvent firms tend to owe unsecured debt to non-bank lenders, other businesses, and the Australian Taxation Office (ATO). Non-bank lenders pose small systemic risks as they make up a small portion of the overall credit market, and banks have limited exposure to them. While defaults on trade credit debts between businesses could potentially transmit financial stress, there is currently no widespread evidence of this happening. The rise in insolvencies is partially due to the ATO's resumption of enforcement activities on unpaid taxes, prompting some struggling businesses to initiate formal insolvency procedures.
The overall risks to the broader financial system, stemming from the business sector, are currently quite low. This conclusion is drawn from two key factors: first, strong demand has enabled businesses to counterbalance higher input costs, and second, there are substantial cash reserves, even though their distribution among businesses may not be equal. While the number of company insolvencies has risen to levels seen before the pandemic, its impact on banks has been minimal. Most of the insolvent companies are small and have relatively small debts, with only a small portion owed to banks.
However, there is a noteworthy risk associated with declining demand. This can negatively affect businesses' profits and their ability to handle their debts. Businesses that heavily rely on discretionary consumer spending or those that can't quickly reduce expenses when their revenue drops, such as those in the arts, recreation, and business services, are facing the most significant challenges in maintaining their profits. Companies burdened with high levels of debt and those already running low on cash reserves are particularly susceptible. In such cases, businesses may have to reduce their workforce, which could potentially lead to financial stress among households.
Source: https://www.rba.gov.au/publications/fsr/2023/oct/household-business-finances-in-australia.html#2.2