23 August 2023 Corporate Stress Rises in the UK

Corporate Stress Rises in the UK​

What do you need to know this week?

The Bank of England published an article yesterday warning that half of UK companies will struggle to service their corporate debt by the end of 2023. This suggests that more UK companies will default on their existing borrowings, which could threaten employment and investments in the UK, as businesses restructure or enter into insolvency proceedings.

Specifically, the Bank of England has been tracking the average interest coverage ratios (ICRs) for UK corporates. This is calculated by dividing a company’s earnings before tax and interest (EBIT) by their annual interest payments. A lower ICR suggests a higher level of corporate stress.

Roughly half of large and medium-sized UK companies will have an ICR of 2.5x or less by the end of the year. This is the highest proportion of stressed ICR figures since the 2007-08 Global Financial Crisis according to the FT.

Why is this important for your interviews?

One way to go about talking about this development is to demonstrate an understanding of why an ICR of 2.5x or less is indicative of stress. To do this, you need to have a passing understanding of basic financial principles.

Below is a simplified profit & loss (P&L) statement of a fictional company, ABC plc:



P&Ls are helpful for determining how efficient a business is in converting its sales (revenue) into profit (earnings).

Profit means different things for different perspectives. Debt investors — i.e., a company’s lenders and other financial creditors — are concerned with how much cash a business can generate to pay all the annual interest on the company’s outstanding borrowings.

P&Ls distinguish between different kinds of expenses to reflect certain relationships such as the fact that interest is an interest deductible expense.

In ABC plc’s case, an ICR of 2.5x suggests limited room to manoeuvre if its financial performance deteriorates. To demonstrate, suppose ABC plc’s revenue falls 10% due to a decrease in customer activity while its operating expenses simultaneously increase by 10% due to inflation.



In this case, ABC plc would not have enough EBIT to service its interest, as illustrated above. This would likely constitute an event of default and could ultimately lead to the company’s demise.

In an interview, you are unlikely to have to work out the numbers as above. But this demonstrates why EBIT is an important measure of a company’s ability to service its debt, and why ICR indicates the extent of a company’s financial stress.

How is this topic relevant to law firms?

The Bank of England’s alarming article reflects the fact that increased interest rates are driving up the cost of credit. This is why M&A and lending transactions have slowed across the board, with the exception of certain private credit and distressed investment activity.

This means that traditional M&A and banking/finance departments have seen a slowdown in deal activity, whereas restructuring teams are seeing increased activity as clients seek to restructure their debt to avoid defaulting.