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When I [Editor Steve] began looking at the role of equity capital in companies, I started out feeling sympathy for company directors, like those of Tunstall, which run businesses saddled with large debts. However, I have learned a few things along the way and my sympathy has evaporated somewhat.
I've also concluded that I understand very little about the magical world of company finance, but I'll do my best to explain how I came to this conclusion after looking through two sets of Tunstall accounts for October 2008-September 2009 which recently become publicly available. [Note for US readers - although Tunstall is privately owned, its accounts are in the public domain.]
The first set of accounts, for Tunstall UK, gives a rosy picture. Profits of £28.7million before tax on turnover of £86.4million. However, Tunstall UK is just one part of the UK-based Tunstall Group, which made the astonishing — to me — loss of £84.1million on a worldwide turnover of £141.7million.
How was this loss achieved? And — this is where my accountancy friends tell me my lack of company finance understanding kicks in — how come a company in this position can still be a going concern? …
Looking at the Group's accounts, these show that Tunstall Group's companies did well in the UK, made small profits in Sweden and Germany and a small loss in the rest of Europe and the world. The overall operating profit was £31.3million, which was reduced to just £2.2million by the application of some technical adjustments such as the amortisation of goodwill, the value of which they have to bring down each year.
So where did the £84.1million loss come from? Simply, there were interest payments of £87.5million.
The accounts list the various loans but, cutting through the detail, it appears that this is the cumulative cost of the private equity financing the company has received over the years through its various buy-outs.
If you marvelled at Malcolm Glazer's purchase of Manchester United with borrowed capital, on which the club has to pay the interest (Wikipedia), you will be familiar with this principle except, of course, the majority of Tunstall is owned by equity capital company Charterhouse General Partners (VIII) Limited.
This is where the topic of company financing got interesting and somewhat mysterious, for me. If I, as an individual, wanted to raise a substantial amount of capital I'd probably have to stake my house against the loan. It's a tangible asset that the loan owner could sell if my finances go belly up and I can't keep up the payments.
According to the Tunstall Group accounts, its borrowings in 2009 were £607.2million. So what assets are company loans are set against?
Tunstall's tangible assets are valued in the accounts at £12.7million. The rest, £453.7million, are intangible assets.
Ah! The magical world of company finance!
Intangible assets are the part of a company's value that arises from the skills, knowledge and creativity of its staff, its business goodwill, and its intellectual property such as copyrights, patents, trademarks and brands. These are all the things that the private equity companies have paid for to generate future profits. They hope.
In effect, private equity companies gamble that the intangible assets will grow their portfolio companies so that they can recoup their capital with a nice profit when they sell them on, probably leaving the companies with yet more debt in the process. If the companies do not perform as expected the private equity companies have the options of hanging on, selling the companies off cheaply, or cutting their losses and pulling the plug on them. As long as the equity companies have backed more winners than losers they will do alright.
My commercially savvy friends tell me that it is not uncommon for companies to carry high levels of debt. The important question is whether their underlying position is sound and reliable, or whether they are shaky. They also tell me that the robustness of a company's cashflow is the most important survival factor.
What I have learned, therefore, is a cautionary tale for any company which wants to sell equity to raise capital for growth.
Without strong cashflow, the equity debt you have incurred can reach levels that you can never pay off, and can eventually cripple you.
To round off this cautionary tale, let's look at how Tunstall is doing in the cashflow stakes. Well, profits are not the same as cashflow, but without them, cashflow flounders. In their report in the Group accounts Tunstall's directors describe 2009 as "a challenging year". But in that year Tunstall UK was still earning well in the aftermath of the UK Government's £80 million Preventative Technology Grant (PTG) and from the Whole System Demonstrator sites. In fact, their gross profit on UK sales seems to have been in the order of 32%.
The PTG (2006–08), plus NHS PASA's now evident inability to negotiate a truly good deal for councils, etc. in the Telecare National Framework Agreement, as witnessed by the size of Tunstall's gross profit, must have been a godsend for Tunstall's cashflow. Not all companies will have such a fortunate combination of circumstances when they need it.
So…to answer the question that had been bugging me, "How come the directors of a company with such a level of debt can still call it a going concern?" My best guess is that if the losses relate to interest payments and not operating costs, then the underlying business is considered to be sound enough. With a large profit margin, they may be right. So no, I don't feel sorry for them.
Steve Hards
5 July 2010
Here are links to download the accounts used to illustrate this item: Tunstall UK 2009 (PDF), Tunstall Group 2009 (PDF). Any Telecare Aware readers who draw different lessons from them or from experience of companies in similar situations, are welcome to add their insights via the comments box below. Please note Telecare Aware's anonymity policy, in the right hand sidebar.
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