Virgin Money Q3 SME Health Check Index by Lesley Brydon

Q3 2019

SME HEALTH CHECK INDEX

Compiled by Cebr in association with Virgin Money UK

DISCLAIMER Whilst every effort has been made to ensure the accuracy of the material in this document, none of Centre for Economics and Business Research Ltd (“Cebr”), Virgin Money UK PLC (“Virgin Money”), or any of their group companies, directors or employees will be liable for any loss or damages incurred through the reliance on or use of this report. This report does not constitute an investment or research recommendation, or any form of investment advice. This report may contain forward looking statements, based on assumptions and/ or targets. Actual results may differ.

Authorship and acknowledgements This report has been compiled by Cebr, an independent economics and business research consultancy established in 1992. The views expressed herein are those of the Cebr only and are based upon independent research by it. The report does not necessarily reflect the views, financial position, business strategy or intentions of Virgin Money, its group companies, or its directors or employees. All lending decisions are subject to status. London, December 2019

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CO N T EN TS

Foreword

Infographic

Executive summary

UK macroeconomic environment

SME business health recovers some lost ground in Q3

In focus: SME business costs inflation

Special report: late payments to SMEs

•

4.1 Scale of the problem

•

4.2 Impact of late payments on SMEs

•

4.3 Trends in late or delayed payments

•

4.4 Potential solutions

•

4.5 Summary of findings

5. Conclusions

6. Methodology

99.9%

52% of all private sector turnover

of all private sector businesses are SMEs

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FORE WORD

Britain’s small and medium-sized enterprise (SME) sector is enjoying a welcome – if small – recovery, reflecting the wider trend in the national economy.

to 1,000 senior SME decision makers to gather their perspective on the problem and shine a light on the disruption it can cause.

The UK’s small businesses have faced an unexpected series of favourable economic indicators in the third quarter of 2019. As a result, the headline Index is up this quarter, regaining the ground lost in Q2.

The findings were striking. In total, 74% of SMEs reported that they had experienced late payment in the last year, while of those, only 14% said that they had not seen disruption to their business as a result. The Government has recently announced new plans to tackle the problem, promising to strengthen the role of Small Business Commissioner, a role created in 2017 to ensure fair payment practices for small businesses.

However, we should not assume that the UK economy, nor the SME sector, is out of the woods by any means. The overall Index score remains low by historical standards, and a continued decline in the number of vacancies shows that SMEs are starting to become more cautious about expanding their workforce. The slow growth in wages and employment figures comes at a time of heightened political and economic volatility, brought about by the continued uncertainty over Brexit. This volatility has risen further in recent months following the announcement of a general election for December. As such, it is likely that SMEs – particularly those exposed to European markets are delaying their hiring decisions until the economic picture becomes clearer, despite the improving indicators elsewhere in the economy. Although macroeconomic and political issues continue to weigh upon the business decisions of SMEs, it is perhaps incumbent on policymakers to think more creatively about viable solutions to the other crucial issues impacting the SME sector. For this quarter’s Index, we carried out some detailed research into the topic of late payments, a problem that has long impacted the sector. As part of the research, we spoke

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While this is a welcome step, more can still be done. Virgin Money supports the Federation of Small Businesses’ (FSB) Fair Pay Fair Play campaign and its three-point plan to tackle the issue. The plan, which calls for greater responsibility for non-executive directors, stronger enforcement of bad practices and the adoption of Project Bank Accounts for major procurements projects, provides policymakers with a set of ready-made and deliverable solutions. We urge other businesses – particularly large organisations – to support the FSB’s campaign. Despite these issues, the Q3 results are cause for optimism. After a challenging start to the year, UK SMEs are showing definite signs of recovery. There are undoubtedly challenges to navigate, and political uncertainty remains a thorn in our economy’s side. However, here at Virgin Money we are committed to helping UK SMEs prosper and grow, and with the right strategy and adequate support, we feel confident they can continue on a positive track.

“ Our Health Check Index reveals that SMEs are enjoying a welcome, if small recovery, reflecting the wider trend in the national economy. A series of favourable economic indicators in Q3 2019 means that the Index is up, regaining ground lost in Q2. “

GAVIN OPPERMAN

Group Business Director

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TA K I N G T H E T E M P E R AT U R E OF TH E U Kâ&#x20AC;&#x2122;S SM E PERFORMANCE

16.6 million

5.9

total employment in SMEs

million

private sector businesses

Small and medium sized enterprises are the engine room of the UK economy.

SME HEALTH CHECK INDEX SCORE

49.0

41.5

Q3 2019

SME Health Check Index

Q2 2019

GDP

100 90 80 -

INDEX SCORE

70 60 50 40 30 20 10 0-

2015

2016

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2016

2017

2018

CHANGES BELOW ARE COMPARED TO Q2 2019

Turnover was estimated at

£2.2

Business Costs 66 (1)

trillion

GDP 66 (15)

Capacity 59 (33)

Lending 61 (4)

Confidence 25 (1) - 0.7% - 0.6

Net business creation 16 (4)

- 0.5% - 0.4% GDP (%)

- 0.3% - 0.2%

Employment 66 (7)

- 0.1% -0

- -0.1% - -0.2

019

2019

- -0.3%

Revenue 33 (9)

East Midlands 45.0 (5.4)

East of England 45.0 (1.9)

London 34.3 (6.4)

North East 49.6 (1.3)

North West 40.5 (5.9)

Scotland 51.5 (10.7)

South East 53.0 (8.9)

South West 49.0 (8.5)

Wales 47.8 (4.8)

West Midlands 39.0 (11.6)

Yorkshire and the Humber 59.6 (19.3)

Up Down From Q2 2019

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The Index recovered the losses sustained during Q2 2019 seven indicators up, nine regions rise and business confidence broadly stable.

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E X ECU T I V E SU M M A RY Small businesses are the engine room of the UK economy. Accounting for 99.9% of businesses, the contribution SMEs make to the UK economy cannot be overemphasised. As well as opening new markets, driving growth and encouraging innovation and creativity, the UK's SMEs also create jobs - employing 16.6 million people in the private sector, equating to more than half of the UK’s workforce. This quarterly report for Virgin Money UK, owner of Clydesdale and Yorkshire Bank (previously CYBG), analyses the health of SMEs in the UK. The result of this analysis is the SME Health Check Index, which combines various statistics and indicators to evaluate the health of businesses and the macroeconomic environment within which SMEs operate. The SME Health Check Index takes on values between 0 and 100. A score of 100 would indicate that all of the SME Health Check Index’s eight indicators are at their highest level since data collection began. A score of 0 would show that all of the eight indicators are at their lowest level since data collection began. The Q3 2019 report finds that: ⊲ The SME Health Check Index recovered the losses sustained during the second quarter of 2019, rising by 7.5 points to reach 49.0 in Q3. ⊲ The UK economy expanded by 0.3% in the third quarter of 2019, following a 0.2% contraction the previous quarter, leading to a 15-point increase in the GDP indicator. The return to positive GDP growth also fed into the revenue and capacity indicators, with the share of SMEs operating below capacity falling to the lowest level in 2019. ⊲ Despite the intense political and economic uncertainty that prevailed during the third quarter, business confidence was broadly stable. This reflects the influence of the uptick in economic activity and slowdown in the rate of business cost inflation balanced by the volatile political climate.

⊲ The only indicator to experience a decline in Q3 was the employment indicator, with the annual rate of employment growth dropping by 0.3 percentage points to 1.0%. This is consistent with broader labour market data, which suggests that hiring activity may be starting to slow following a remarkable phase of expansion in recent years. ⊲ The annual rate of business cost inflation fell to the slowest pace since 2017, driven by year-on-year declines in the cost of commercial rents and a sharp slowdown in the rate of price growth of physical inputs. The latter factor had a particularly large impact on firms in the manufacturing sector, which typically rely more on physical inputs than firms in other sectors of the economy. ⊲ SMEs in most parts of the country saw the benefits from the rebound in economic activity that took place in the third quarter of 2019. Indeed, gains in the SME Health Check Index were recorded in nine out of the 11 regions covered. ⊲ The most sizeable improvements to the health of SMEs were seen in Yorkshire & the Humber and the West Midlands, which saw an 19.3 and 11.6 point increase in the SME Health Check Index respectively. Both of these regions were able to buck the national employment trend in Q3, with each experiencing an acceleration in the annual rate of employment growth.

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⊲ The only two regions to record a decrease in the SME Health Check Index in Q3 were Wales and the East Midlands. The Index score for Wales was dragged down by a 1.6% annual contraction in the number of people in employment, while the East Midlands’ score was adversely impacted by a fall in the share of SMEs that reported an increase in revenues over the past three months. ⊲ The issue of late payments is brought into focus in a special chapter of this report. A survey of 1,000 senior SME decision makers finds that 74% of SMEs have experienced late payments from customers over the past 12 months. On average, SMEs reported that 13% of their payments from customers over the last 12 months were received at a date later than set out in the agreed terms of payment.

9/11 regions saw a rise in their Index scores

⊲ 86% of SMEs that have experienced late payments from customers over the past 12 months stated that this has had a disruptive impact on their business. Commonly cited disruptions include the depletion of company reserves, postponement of investments, and difficulties paying staff. The survey results also show that each late payment has a multiplicative effect, leading to other late payments further down the supply chain. Indeed, 88% of SMEs that have paid a supplier late over the past 12 months indicated that a late payment from one of their customers had contributed to this. ⊲ The frequency of late payments is lower among SMEs with the most stringent payment terms. Among businesses that require payment immediately upon receipt of an invoice, the share of payments made late over the past 12 months was 8%. This figure rises to 18% among SMEs that require payment within 30 days of receiving an invoice.

7/8 indicators up

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1. U K M ACRO ECO N O M I C EN V I RO N M EN T Against the backdrop of a highly charged and discordant atmosphere in Westminster, the UK economy showed some signs of life in the third quarter of 2019, expanding by 0.3% between July and September. Although this meant that the UK has avoided entering into a technical recession – defined as two consecutive quarters of contraction – the UK economy is not out of the woods by any means. Indeed, the annual growth rate of GDP dipped to an eight-year low of 1.0% in Q3. Households have continued to act as the major engine for growth. Notwithstanding the marginal fall in the employment rate in Q3, the labour market has remained in decent shape, which will have buoyed consumer spending in recent months. However, a slowdown in the rate of average wage growth together with a continued decline in the total number of vacancies – which is now at its lowest in two years – suggest that household spending could come under pressure in the months ahead. Elsewhere in the economy, companies continued to exercise caution in the third quarter, with zero growth in business investment between Q2 and Q3 a likely symptom of the prevailing climate of uncertainty. As the UK gears up for its third general election in four and a half years, the country looks poised to enter a period of expansionary fiscal policy, with all major political parties proposing to increase government spending significantly if they come to power. As the employment expansion that has fuelled the economy in recent years begins to lose steam, tackling the UK’s chronic productivity problem will be of central importance in the years ahead. Investments in training and infrastructure – both by businesses and government – will play a key role in shaping the UK’s productivity growth in the future.

On the whole, the UK economy exceeded expectations in Q3, although this is more reflective of the weakness of expectations than the strength of performance. This story was mirrored elsewhere in the global economy, with Germany managing to escape a recession while the slowdown in the US was less pronounced than anticipated in the third quarter. This will have contributed somewhat to the recovery of UK exports, which grew by 5.2% over the third quarter following a 6.6% contraction between Q1 and Q2. Looking ahead, it is concerning that while economic growth returned to positive territory over Q3 as a whole, the economy actually contracted during the months of August and September, suggesting a loss of momentum going into the final quarter of 2019. Uncertainty continues to act as a significant drag on the UK economy. While the outcome of the December election may provide some clarity for the short term, further phases of the Brexit negotiations will mean that a clear and detailed picture of the UK’s future relationship with the EU will elude businesses in the coming quarters.

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2. S M E BUS I N E SS H E A LT H R ECOV ER S SO M E LOS T G RO U N D I N Q3 SMEs are a key component to the success of the UK economy. Making up more than 99% of all UK businesses, SMEsâ&#x20AC;&#x2122; commitment to achieving their goals helps drive the country's growth. For the SME Health Check Index, we are not only analysing different variables that can be directly linked to the performance of SMEs, such as confidence and revenue, but also the business and macroeconomic environment in which SMEs operate. The following section begins by presenting the overall results of the SME Health Check Index and its indicators, before turning to regional comparisons. The SME Health Check Index saw a significant improvement in the third quarter of 2019, with the score rising by 7.5 points to 49.0. Prior to the latest quarter, the Health Check Index had fallen consistently and considerably in 2019, reaching its lowest ever level in Q2. The recovery in Q3 means that the Index has now wiped out the losses sustained during the difficult second quarter, but remains at a low level by historical standards. There was a broad-based improvement across the majority of indicators, with only the

employment indicator recording a decline in the third quarter of 2019. Economic output recovered in Q3 following the 0.2% contraction the previous quarter. This supported notable gains in the GDP, capacity and revenue indicators. Meanwhile, business cost inflation continued to recede in Q3, while the lending and confidence indicators also rose. The following section analyses the indicators of the SME Health Check Index in more detail.

FIGURE 1: SME HEALTH CHECK INDEX (SOURCES FSB, ONS, UK FINANCE, CEBR ANALYSIS)

SME Health Check Index

GDP

100 -

- 0.7%

90 -

- 0.6%

80 -

- 0.5%

70 -

- 0.4%

60 -

- 0.3%

50 -

- 0.2%

40 -

- 0.1%

30 -

- 0%

20 -

- -0.1%

10 0-

- -0.2%

2014

2015

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2016

2017

2018

2019 2019 2019

- -0.3%

GDP (%)

INDEX SCORE

- 0.8%

Business Costs Business costs rose at an annual rate of 2.4% in Q3 2019. This is 0.1 percentage points below the rate recorded in Q2 and 0.5 percentage points lower than at the same point last year. The slowdown in business cost inflation reflects falling commercial rents and declines in the rate of price growth for energy, transport, business services and key physical inputs. Capacity The capacity indicator increased from 26 to 59 between the second and third quarters of the year, as the share of SMEs operating below their full capacity fell to the lowest level since the end of 2018. This is consistent with the recovery of economic activity in Q3, which will have meant fewer SMEs operating with spare capacity. Confidence Business confidence – as measured by the Federation of Small Businesses’ (FSB) Voice of Small Business Index1 – increased marginally in the third quarter of 2019, but remains well below the levels seen in past years. Lower cost pressures and a recovery of economic activity will have lifted sentiment to some extent among the SME community, despite the intense political uncertainty. Employment The labour market has been showing signs of softening in recent months, with the employment rate edging down from a previous record high and the number of vacancies falling by 11,000 between Q2 and Q3. Moreover, the total number of people in employment declined by 58,000 over the third quarter, bringing the

annual rate of employment growth down from 1.3% to 1.0%. This suggests that the significant acceleration of wage growth recorded this year may be starting to have an impact on employers’ appetite for hiring. Despite the emerging warning signs, it is important to note that the labour market remains very tight by historical standards. Nonetheless, the slowdown in the rate of employment growth made the employment indicator the only indicator in the Health Check Index to record a fall in Q3, decreasing by seven points to 66. GDP Economic growth returned to positive territory in Q3, with GDP expanding by 0.3%. This was driven by a 0.4% quarter-on-quarter increase in household expenditures. Consumption growth was facilitated to a large degree by the robustness of the labour market, as well as a slowdown in consumer price inflation, which has supported growth in real incomes. While the UK was able to avoid a technical recession, the annual rate of GDP growth is now at its lowest since Q1 2010. Moreover, growth was concentrated in the first month of Q3, suggesting some loss of momentum towards the end of the quarter. Lending to SMEs Although the value of SMEs’ outstanding loan and overdraft balances fell by £109 million between Q1 and Q2 (the latest quarter for which data is available), the annual rate of contraction fell slightly to 1.5%, leading to a small improvement in the lending indicator. According to the Bank of England’s Credit Conditions survey, the availability of credit for the corporate sector was hit by a changing appetite for risk in Q2. In the months ahead, lenders have also indicated that a worsening economic outlook could further impact the availability of credit to businesses.

Federation of Small Businesses: Voice of Small Business Index – Q3 2019

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Net Business Creation

Revenue

The number of incorporated companies in the UK increased by 42,000 during the third quarter of 2019. Just under 130,000 firms were dissolved between July and September, although this was offset by the incorporation of 170,000 new companies and the restoration of 2,000 companies to the Companies House register. These movements pushed the annual rate of net business creation to 4.1% in Q3 â&#x20AC;&#x201C; up from 4.0% the previous quarter. Despite the improvement, the rate of business creation remains far below the levels recorded prior to 2018.

The strong household spending figures recorded in the third quarter translated into a larger share of SMEs reporting an increase in their revenues in Q3. This led to a nine-point increase in the score for the revenue indicator, from 24 in Q2 to 33 in Q3. As the rate of growth of average real earnings has stabilised in recent months, growth of retail sales volumes has also slowed considerably. If wage growth and employment growth continue to slow in the coming months, this could soon lead to a downward pressure on the revenue indicator as households are forced to rein in their spending.

FIGURE 2: SUB-COMPONENTS OF THE SME HEALTH CHECK INDEX (SOURCES: FSB, ONS, UK FINANCE, CEBR ANALYSIS) 100

0 Business Costs

Capacity

Confidence

Employment Q2 2019

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GDP Q3 2019

Lending

Net Business Creation

Revenue

2.1 R EG I O NA L B R E A KDOW N O F TH E SM E H E ALTH CH ECK I N D E X

This section of the report investigates regional differences in the SME Health Check Index, in order to understand which parts of the UK currently present a more favourable business and macroeconomic environment for SMEs. We divide the UK into the nine English government office regions (East Midlands, East of England, London, North East, North West, South East, South West, West Midlands and Yorkshire & the Humber), as well Scotland and Wales. Nine out of the 11 regions covered recorded gains in the SME Health Check Index in Q3 2019. This is a reversal of the previous quarter when eight regions registered declines in the Index. The most sizeable improvements in the business climate were seen in Yorkshire & the Humber and the West Midlands, which experienced a 19-point and 12-point increase in the SME Health Check Index, respectively. In both instances, this was led by a sharp recovery of the GDP, revenue and capacity indicators, symptomatic of the uptick in economic activity that took place in the third quarter of the year. The East Midlands and Wales stood out from other regions in that they both saw a five-point decline in the SME Health Check Index in Q3.

FIGURE 3: REGIONAL SME HEALTH CHECK INDEX (SOURCES: FSB, ONS, BBA, CEBR ANALYSIS)

0 East Midlands

East of England

London

North East North West South East

Q2 2019

East Midlands The East Midlands bucked the national trend in Q3 by recording declines in the revenue, capacity and confidence indicators. This fuelled a 5.4 point fall in the SME Health Check Index for the region, taking the score to 45.0. These results suggest that the pick up in economic activity seen by the UK as a whole was significantly less pronounced in the East Midlands. It is interesting to note however that the annual rate of employment growth accelerated to 3.4%, meaning that the region has now had the fastest rate of employment growth in the UK for two consecutive quarters. The fact that firms in the region are continuing to take on new staff at such a fast pace goes some way to explaining

South West

West Midlands

Yorkshire & the Humber

Scotland

Wales

Q3 2019

the increased share of businesses that are operating below their full capacity. Many manufacturing firms in the region have been hit hard by the sectoral slowdown brought about by slowing global trade and prolonged economic uncertainty. However, a piece of good news in recent weeks has come from the sale of Jena Tec Precision Ltd to Motion Control Engineering Ltd, the former having entered administration in September, citing a nationwide slowdown in business and consumer confidence. East of England Improvements in the capacity and GDP indicators contributed to a 1.9 point increase in the SME Health

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Check Index for the East of England, bringing the score to 45.0. The rise in the Health Check Index was more muted in this region than elsewhere in the UK, largely due to significant falls in the confidence and revenue indicators. Indeed, the share of SMEs based in the East of England that reported an increase in their revenues over the past three months is now at the lowest point since the Index began in 2014, while SME sentiment in Q3 also reached its lowest point since the inception of the Health Check Index. This highlights that although a fall in cost inflation and uptick in demand supported business confidence for the UK as a whole last quarter, the volatility of the domestic and international outlook continues to erode SME sentiment in many parts of the country. The share of SMEs in the construction sector is higher in the East of England than any other part of the UK. Analysis by the Migration Observatory shows that construction roles are among those that rely the most on EU labour,2 and the potential for a reduced access to these workers post-Brexit will represent a key concern for many local businesses in the sector. London The SME Health Check Index for London rose by 6.4 points to 34.3 in Q3, recovering some of the lost ground following the dramatic deterioration of the business environment the previous quarter. London’s score in the Health Check Index continues to be held back by weakness in the employment indicator. The number of people employed in the capital in Q3 was 26,000 lower than it was at the same point last year, meaning that London is one of only two regions to have a negative rate of annual employment growth. This represents a marked reversal of fortune, since London recorded some of the fastest rates of employment growth in the UK in 2018. Net EU migration to the UK has been falling consistently and considerably in recent years, which will be a factor weighing on the shrinking numbers of people in employment in London – given the high propensity for immigrants to settle in the capital. While policymakers have often emphasised the need to rebalance the economy away from London, the capital is nonetheless home to some of the largest proposed infrastructure developments in the country. The

outcome of reviews into major schemes such as HS2, the third runway at Heathrow airport, and Crossrail 2, will heavily influence the overall levels of investments that London receives over the next decade. North East In the North East of England, the SME Health Check edged up by 1.3 points in Q3, taking the score to 49.6. The annual rate of growth of SMEs’ outstanding loan and overdraft balances was the second highest in the UK in the North East in Q2, suggesting that firms in the region do still have the confidence to invest despite the challenging economic and political climate. Indeed, SME sentiment rebounded somewhat in Q3, although it remains considerably more subdued than in 2018. A more significant increase in the SME Health Check Index was prevented to a large degree by the revenue indicator, which fell by 17 points to 33 in the third quarter of 2019. This is the lowest the indicator has been since Q4 2017. Despite a resurgence in July, manufacturing output in the UK returned to contractionary territory in August and September, which will have dented SMEs’ revenues in the North East. As one of Europe’s leading hubs for electric vehicle manufacturing, Tesla’s recent decision to locate a major new factory in Germany over the UK represents a blow for the region. While Germany’s pedigree in the automotive field was a key consideration for this decision, Tesla CEO, Elon Musk, also cited Brexit uncertainty as having made the UK too risky a destination. North West The SME Health Check Index for the North West increased by 5.9 points to 40.5 in Q3 2019 – the highest level recorded so far this year. The capacity and revenue indicators both registered solid gains in the third quarter, in line with the UK average. In particular, the share of SMEs in the North West that stated their revenues had increased over the past three months rose to the highest level in more than two years. The employment indicator fell for the third consecutive quarter to 32, as the annual rate of employment growth declined to just 0.1% in Q3. Investment into Manchester – the region’s largest city – has been booming in recent years, with high levels of both residential and office construction. Indeed, Deloitte’s regional crane survey finds Manchester outperforms most major UK cities

2 https://migrationobservatory.ox.ac.uk/resources/briefings/migrants-in-the-uk-labour-market-an-overview/

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when it comes to the number of cranes in the sky. Manchester also stands out at an international level in this respect, with Toronto the only North American city with a higher number of cranes on the skyline.3 The regional economy received a further boost recently from the announcement of a direct flight connection between Shanghai and Manchester Airport from March 2020. It is hoped that this will support tourism and investment in the region following the success of the introduction of flight routes to Beijing. Scotland The number of people in employment in Scotland in Q3 was nearly 43,000 below the level in Q2. This contributed to a 0.8% year-on-year decline in employment, and an 18-point fall in the employment indicator from 54 to 36. Despite the concerning trends in the Scottish labour market, the SME Health Check Index as a whole shows a substantial improvement in the third quarter of 2019, with the score rising by 10.7 points to 51.5. The revenue indicator rebounded from a record low in Q2 to the highest level since 2015, while the share of Scottish SMEs operating below full capacity also fell to the lowest level since Q4 2015. These results are an encouraging signal for the SME community in Scotland, suggesting that economic activity picked up following a highly challenging second quarter. The issue of climate change has risen in prominence in recent months, with parties from across the political spectrum expanding their pledges to address the UK’s carbon emissions. The UK’s transition to a greener energy system provides a major opportunity for Scotland, which is already a leader in renewable power generation. For instance, Scotland is home to the world’s first floating wind farm off the coast of Peterhead. Innovative technologies such as these have the potential to deliver a considerable boost to many sectors of the Scottish economy. South East The South East registered improvements in all but one of the indicators in the SME Health Check Index in Q3. This led to an 8.9 point increase in the Index score to 53.0. Employment in the South East has risen by more than 129,000 over the past year, meaning that the corresponding indicator is now at the highest level since

the start of 2014. For growth in employment levels to be sustained, there has to be both a demand for new workers from firms, as well as the appropriate distribution of skills among the local population to fill these roles. The workforce in the South East is among the most qualified in the country, which will have facilitated the strong labour market gains in recent months.4 Elsewhere in the SME Health Check Index, there were increases in the revenue, capacity and GDP indicators. Despite the overall improvement in the business environment in Q3, SME sentiment in the South East fell to the weakest level since the Health Check Index began in 2014. There are numerous factors that could have undermined business confidence in Q3, ranging from the possibility of a disorderly Brexit to trade tensions and an overall slowing of the global economy. South West The SME Health Check Index climbed by 8.5 points to reach 49.0 in the South West in the third quarter of 2019. This is despite a slight increase in the share of SMEs operating below their full capacity and a worsening of business sentiment – trends that are at odds with the UK as a whole. The improvement in the Index was driven by increases in the revenue, lending and employment indicators. At 2.1%, the annual rate of employment growth in the South West is now more than twice as high as the UK average. Plans for the development of a major manufacturing facility at a disused coal site in North Somerset would deliver a further boost to investment and employment in the region.5 Elsewhere in the South West, a decision regarding the expansion of Bristol Airport has been postponed. Proponents of the scheme highlight the improved access to international markets that the expansion would deliver, although environmental concerns ranging from climate impacts to noise pollution persist. Wales Wales was one of only two regions to register a decline in the SME Health Check Index in Q3. Between the second and third quarters the Index score fell by 4.8 points to 47.8 – the lowest level since the SME Health Check Index began in 2014. The value of Welsh SMEs’ outstanding loan and overdraft balances fell by

3 https://www.buyassociation.co.uk/2019/02/05/manchester-construction-hits-record-heights/ 4 https://workplaceinsight.net/wp-content/uploads/2019/11/Good-Growth-for-Cities.pdf 5 https://www.bristolpost.co.uk/news/bristol-news/huge-manufacturing-plant-planned-redundant-3507662

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£90 million between Q2 2018 and Q2 2019, pushing down the score for the lending indicator to 48. This suggests that many businesses in Wales are cautious to commit to hard capital investments, given the climate of uncertainty that persists in the UK. This unease is also reflected in the confidence indicator, which fell by 46 points to 33 in the third quarter of 2019. The results of the SME Health Check Index suggest that the revival of economic activity in the UK was not felt as strongly in Wales. The number of people in employment in Wales fell by 1.6% in the year to Q3 – the steepest rate of decline in the country. Meanwhile, the share of Welsh SMEs that reported an increase in revenues over the past three months dropped to a four-year low. West Midlands After suffering a large fall in the SME Health Check Index between Q1 and Q2, the score for the West Midlands rose by 11.6 points to 39.0 in the third quarter of 2019. Both the revenue and capacity indicators have picked up slightly after sinking to record lows in Q2. Meanwhile, the number of people employed in the West Midlands was more than 20,000 higher in Q3 than it was the previous quarter, which pushed up the annual rate of employment growth to 1.4%. The volatility of the indicator movements through 2019 suggests that SMEs in the West Midlands have been particularly impacted by the stockpiling activities that took place ahead of the original March 29th Brexit deadline and the associated swings in economic activity. The prospects for the regional economy received a boost in Q3

19.3

when full approval was given to unlock £22.5 million in funding for the development of a major industrial site in Wolverhampton that is forecast to create around 1,700 new jobs. 6 Yorkshire & the Humber The health of SMEs in Yorkshire & the Humber improved markedly in the third quarter of 2019, as the SME Health Check Index rose by 19.3 points to 59.6. This is by far the largest quarterly increase in the UK, and more than offsets the significant decline between Q1 and Q2. Yorkshire & the Humber was the only region to record an improvement in all of the eight indicators that feed into the Health Check Index. The largest gains were made in the capacity, confidence and revenue indicators, which suggests the local economy was in good shape in Q3. Although the annual rate of employment growth is well below the national average, it did return to positive territory in Q3, after the net addition of nearly 5,000 jobs during the third quarter. The value of SMEs’ outstanding loans and overdrafts also rose by £112 million in the year to Q2 2019, providing a positive signal of businesses’ willingness to invest despite the climate of uncertainty. The painful experience of widespread and severe flooding across the region, which displaced 2,000 people and led to the declaration of a climate emergency in South Yorkshire, has focussed minds on the need for further investment in flood protection. While the recent flooding was caused by the River Don, tidal flooding also represents a major risk for people and businesses in the region – particularly in Hull, which is among the cities most exposed to coastal flooding and sea level changes. In response to this risk, a highly ambitious, £1.5 billion scheme was unveiled in October for the creation of a lagoon on the Humber Estuary. If the scheme were to become a reality, it would have sizeable impacts for the local economy, ranging from the creation of new jobs associated with the construction and maintenance of the structure to the productivity gains that would arise from the accompanying transport developments.

point increase in Yorkshire & the Humber

6 https://www.birminghammail.co.uk/black-country/next-stages-1700-jobsite-16906579

3. I N FOCUS: S M E BUS I N E SS COS TS I N FL AT I O N In this section, we explore the business costs indicator in greater detail in order to examine the cost pressures faced by SMEs during the third quarter of 2019, and the degree to which rising input prices have affected businesses in different industries and regions. FIGURE 4: SME INFLATION Q1 2014 – Q3 2019

3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 2018 2019 2019 2019

The annual rate of business cost inflation fell to the lowest level in more than two years in the third quarter of 2019, edging down by 0.1 percentage points to 2.4%. The unstable political and economic environment has left its mark on the real estate market, with commercial rents down 0.2% in the year to Q3. Meanwhile, a softening of oil prices contributed to a slowdown in the rate of inflation for transport, electricity and gas. Drone attacks on two Saudi Arabian oil facilities in September led to an initial 20% surge in oil prices, though the price swiftly receded after it became apparent that production could resume earlier than predicted. However, the episode underlined the havoc to the global economy that would accompany an escalation of tensions in the Middle East. Since 2016, physical inputs such as metals, chemicals and wood have been a major driver of business cost inflation. For instance, at its peak in early 2017, the annual rate of inflation for basic metals reached 18.4%, while the rate of price growth for chemicals also approached 10% that year. Fast forward to today,

chemical prices have fallen year-on-year and the annual rate of inflation for basic metals has dropped to 1.1%. Given that large shares of these inputs are imported, currency movements are a significant factor driving these movements. While the post-EU referendum depreciation of the pound had the effect of pushing up the price of imports, the strengthening of the pound between August and November will have the opposite effect in the coming months. The decline in the annual rate of business cost inflation was mirrored by a fall in the rate of consumer price inflation in Q3 – a possible sign of waning underlying demand in the UK economy. Since there is a degree of overlap between the prices faced by consumers and those faced by businesses, the fall in the rate of consumer price inflation will have also lessened businesses’ input cost pressures. A source of upward pressure on the overall rate of business cost inflation came from employment costs, which rose by 4.0% in the year to Q3 2019 – up from

#SMEhealthcheck | Q3 2019 REPORT 19

3.7% the previous quarter. While a historically low level of unemployment has been driving up average earnings so far this year, there are signs in the most recent data that the labour market may be starting to soften somewhat. For instance, in the three months to October, the number of vacancies sunk to the lowest level since Q3 2017. If this trend continues,

employment cost pressures may well start to subside in the months ahead. An important dynamic is the absence of the productivity growth that is essential for sustainable increases in wages. Indeed, output per hour worked was the same in Q3 2019 as it was during the same period the previous year, while there was a 0.5% year-on-year decline in Q2.

FIGURE 5: BREAKDOWN OF COSTS FACED BY SMES

The price movements described above have had a dramatic impact on the relative scale of the cost pressures faced by SMEs in different industries. Since the middle of 2016, the annual rate of business cost inflation for manufacturing SMEs was considerably above the UK average. However, the sharp slowdown in the rate of price growth of physical inputs has reversed this dynamic, with the rate of inflation for the manufacturing sector sinking to 2.1% in Q3. Elsewhere, a decline in the rate of inflation for road freight contributed to a 0.3 percentage point fall in the overall rate of business cost inflation for retail SMEs, which now stands at 2.2%. Meanwhile, industries that are more reliant on labour inputs have seen an intensification of cost pressures. For instance, the annual rate of business cost inflation for SMEs in the business services sector rose from 2.9% to 3.0% between Q2 and Q3.

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22.4%

Physical inputs

29.7%

Employment costs

5.0%

Rent and utilities

15.7%

Construction

3.6%

Transport and storage

20.5%

IT, business and financial services

3.1%

Other

As cost pressures have eased for manufacturing SMEs and increased for SMEs in the service sector, the average rates of business cost inflation have shifted across the UK’s regions. In the third quarter of 2019, regions with a larger industrial base – namely the East Midlands, the West Midlands, Yorkshire & the Humber, and Wales – saw an annual rate of business cost inflation of 2.4%. Meanwhile, the annual rate of inflation for the remaining parts of the UK – where employment costs form a larger part of the overall basket of inputs – was 2.5%. If the labour market continues to soften in the coming months, this would likely lead to an even greater balancing of the rate of business cost inflation between the UK’s regions.

4. S PECI A L R EPO RT: L AT E PAY M EN TS TO S M E S The highly competitive and rapidly evolving environment in which SMEs operate means that many businesses are in a perpetually precarious position. This is evidenced by the fact that only around two in five (42%) UK businesses make it to their fifth birthday. Although efforts are justifiably focussed on the acquisition of new customers and retention of existing customers, a business’ survival also depends on receiving timely payments from customers for the goods or services provided. Late payments from customers are a significant challenge faced by SMEs across the country, and affect their ability to plan and invest for the future, maintain production, meet expenditure commitments, and – in extreme cases – remain in operation altogether. Data from the Department for Business, Energy & Industrial Strategy’s (BEIS) Small Business Survey of more than 10,000 SMEs show that late payments are among the largest concerns held by the UK’s SMEs. In 2018, a third (33%) of SMEs indicated that late payments from customers were a major obstacle to their success. This is similar to the share that cited issues with staff recruitment and skills as a major obstacle to success, and is significantly greater than the share citing Brexit, the cost of premises, or obtaining finance.

FIGURE 6: MAJOR OBSTACLES TO THE SUCCESS OF SMEs (SOURCES: DEPARTMENT FOR BUSINESS, ENERGY AND INDUSTRIAL STRATEGY, CEBR ANALYSIS) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Competition in the market

Regulations and red tape

Tax

Staff recruitment and skills

Late payments

Brexit

Availability / cost of premises

National living wage

Workplace pensions

Obtaining finance

The issue of late payments leaves a mark on many of the indicators tracked by the SME Health Check Index. Failure to receive a timely payment from a customer can in many cases require the supplier to seek external finance in order to maintain cashflow, which feeds into the lending indicator. Meanwhile, the uncertainty generated by a high incidence of late payments can have a significant impact on business sentiment. The instability of cashflows also affects business’ ability and willingness to invest, which has ramifications for the capacity indicator of the SME Health Check Index. Furthermore, late payments can be a factor contributing to the closure of SMEs, which therefore weighs on the rate of net business creation.

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This chapter of the SME Health Check Index explores in detail the issue of late payments to SMEs, in order to shed light on the scale of the problem, the impacts on businesses, in addition to the potential solutions. Data for this analysis has come from a bespoke survey of 1,000 senior SME decision makers in the UK 7, as well as from BEIS’ Small Business Survey.

4.1

Scale of the problem

The results of the bespoke survey confirm that the issue of late payments is one that is widespread and deeply entrenched among UK SMEs. Indeed, less than a quarter (23%) of respondents indicated that they have not received any late payments over the past 12 months. On average, SMEs reported that more than one in eight (13%) of the payments they have received over the last 12 months were received at a date later than set out in the agreed terms of payment. Meanwhile, 22% stated that more than a fifth of payments made to their business had been late. A geographical breakdown of the results confirms that the issue of late payments is prevalent throughout the country, although there does exist a significant degree of regional variation. In London, SMEs reported that for every six payments they received, one was made at a later date than set out in the agreed payment terms. London has more businesses per working age adult than any other region or nation in the UK. This is indicative of a highly competitive business environment comprised of many complex supply chains. This can increase the incidence of late payments by diminishing the power of individual firms to enforce stringent payment terms. FIGURE 7: SHARE OF PAYMENTS OVER THE PAST 12 MONTHS THAT WERE MADE LATE, BY UK REGION (SOURCES: CENSUSWIDE, CEBR ANALYSIS) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Greater London

East of England

West Midlands

South West

North West

Wales

East Midlands

Scotland

Yorkshire and the Humber

South East

North East

It is apparent from the survey results that late payments are far more common with business to business transactions than they are with business to consumer interactions. Indeed, in the manufacturing sector, SMEs reported that on average, more than a fifth (22%) of payments received over the past 12 months were made late. This is nearly double the UK average rate of late payments. There is a similar picture in the construction sector, where the average share of late payments over the past 12 months is 19%. These markets are in a lot of cases oligopsonies – defined as having only a handful of correspondingly influential buyers. As a result, it is easier for customers in these markets to dictate payment terms or renege on commitments, given that they are such a large component of their suppliers’ customer base.

Survey conducted by Censuswide between 8th November and 15th November 2019.

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By contrast, in consumer-facing industries, the share of payments that are made late is considerably lower. This is because, in markets with thousands or indeed millions of distinct consumers, suppliers are more able to enforce payment terms at an individual level without jeopardising their relationship with as large a share of their total customer base. In the retail & wholesale sector, SMEs in the survey reported on average that 9% of payments over the past 12 months were made late, while in the hospitality & leisure sector this share falls to just 8%. Historically, it would be expected that the rate of late payments in consumer-facing industries would be close to zero, given that payment is typically required at the point at which the goods or services are provided (or indeed prior to this point). However, the spread of retail finance and â&#x20AC;&#x153;buy now, pay laterâ&#x20AC;? promotions has left some retailers more exposed to the risk of late payments. FIGURE 8: SHARE OF PAYMENTS OVER THE PAST 12 MONTHS THAT WERE MADE LATE, BY INDUSTRY (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

25% 20% 15% 10% 5% 0%

Manufacturing

Construction

Financial services

IT & telecoms

Education

Media, marketing, PR & sales

Medical and health services

Retail & Wholesale

Hospitality and leisure

The sectoral breakdown presented in Figure 8 provides some evidence for the idea larger companies are more able to delay payments to suppliers by virtue of their size. This is reinforced by the fact that nearly two in five SMEs (38%) feel that they are much more likely (14%) or somewhat more likely (24%) to receive late payments from large companies as opposed to small and medium sized companies. This is more than twice the share (18%) that stated that late payments were less likely to come from large companies. Moreover, nearly two thirds (62%) of SMEs agree that large companies take advantage of their position as a major customer to make late payments to their suppliers, compared to less than one in 10 (10%) that disagree. These results are corroborated by the 2016 Small Business Survey, which finds that 60% of small businesses received at least one late payment from a large business customer over the previous year. Meanwhile, only in around a third (35%) of these cases did the small business raise a dispute with the larger business customer following the late payment. Interestingly, while 74% of SMEs reported having received late payments from customers over the past 12 months, less than half (46%) stated that they themselves have made a payment to a supplier at a date later than agreed in the terms of payment. Moreover, SMEs on average estimated that 6% of their payments to suppliers over the past 12 months were made late. This is less than the 13% of payments from customers that SMEs on average estimate were made late during the same period. This discrepancy confirms that while many late payments occur during transactions between SMEs, there are also a high number of cases in which large companies make late payments to their smaller suppliers.

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FIGURE 9: RATES OF AGREEMENT WITH THE STATEMENT: “LARGE COMPANIES TAKE ADVANTAGE OF THEIR POSITION AS A MAJOR CUSTOMER BY MAKING LATE PAYMENTS TO SUPPLIERS” (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

4.2

21%

Strongly agree

42%

Agree

21%

Neither agree nor disagree

Disagree

Strongly disagree

Impact of late payments on SMEs

Among the nearly three quarters (74%) of SMEs that have experienced late payments from customers over the past 12 months, only a small fraction (14%) stated that this has not disrupted their business’ operations. Meanwhile, 23% of respondents indicated that late payments had been highly disruptive to operations, while 63% said that they had been slightly disruptive. Failure to comply with payment terms has had the most acute impact on SMEs in Scotland and the South West, where 91% of SMEs that have experienced late payments over the past 12 months stated that this has been disruptive to their operations. Late payments from customers mean that suppliers temporarily lose out on a source of revenue that they rely on to meet their expenditure commitments. The primary way in which SMEs can address this challenge is to dip into the company reserves – assuming of course that there are sufficient reserves to cover the cashflow deficit. Nearly a third (31%) of SMEs in the survey have had to reach into their company savings in order to maintain cashflow following late payments by customers. However, easy access to a pool of liquid capital is a luxury not all SMEs enjoy. Indeed, one in 10 small and medium sized businesses have had to apply for external finance as a result of late payments from customers, while 3% have had to sell company assets to resolve the cashflow challenge arising from a late payment. Another crucial impact of late payments is on SMEs’ ability to plan and invest for the future. Nearly one in six (16%) SMEs in the survey stated that they have delayed or postponed business investments as a result of late payments from customers. Across the UK, business investment has been flat or contracting during six out of the last seven quarters. The cumulative effect of this is that business investment in Q4 2017 was more than 3% higher than it was in the third quarter of 2019. While economic and political uncertainty are often touted as the driver of this weakness in investment, the results of the survey highlight that the volatility to cashflows that late payments generate is also an important factor underlying businesses’ unwillingness or indeed inability to invest.

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FIGURE 10: DISRUPTIONS TO SMES RESULTING FROM LATE PAYMENTS (SOURCES: CENSUSWIDE, CEBR ANALYSIS) 35% 30% 25% 20% 15% 10% 5% 0% Dipping into company reserves to maintain cashflow

Diffcullties paying suppliers on time

Deployment of resources to chase late payments

Delaying and postponing business investments

Difficulties Applying Difficulties paying staff on for external paying rent on time finance in order time to maintain cashflow

Delaying / postponing the training of existing employees

Delaying / Reducing staff Selling company Laying-off staff postponing the working hours assets to to control costs hiring of new to control costs maintain employees cashflow

The modern economy provides many striking examples of the complex and often crowded nature of supply chains, from the numerous layers of administrative, management and construction companies that separate landlords from tenants, to the multitude of businesses that feed into the production of consumer electronics. One consequence of the highly complex and inter-connected supply chains in which businesses operate is that a single delayed payment can rapidly cascade down the supply chain. The results of the survey confirm that this is the case: among the 43% of SMEs that have both received late payments from customers and made late payments to suppliers over the past 12 months, 30% stated that late payments from customers directly resulted in them making late payments to suppliers. Meanwhile, 59% said that late payments from customers had contributed to them making late payments to suppliers, and only 11% indicated that this had not had an impact.

FIGURE 11: IMPACT OF LATE PAYMENTS FROM CUSTOMERS ON MAKING LATE PAYMENTS TO SUPPLIERS (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

40% 35% 30% 25% 20% 15% 10% 5% 0% Directly resulted in late payments to suppliers

Contributed significantly to late payments to suppliers

Contributed a small amount to late payments to suppliers

Not contributed to late payments to suppliers

#SMEhealthcheck | Q3 2019 REPORT 25

4.3

Trends in late or delayed payments

The issue of customers paying suppliers after the date agreed in the terms of payment has become more widespread in recent years, according to the results of the survey. Indeed, nearly half (48%) of SMEs feel that the frequency of late payments has significantly (10%) or slightly (38%) increased over the last five years, compared to 13% that feel the frequency has decreased. To investigate this trend further, the balance sheets and income statements of the 10 largest non-financial companies listed on the London Stock Exchange by market capitalisation have been analysed between 2008 and 2018. 8 The companies analysed operate in a broad range of sectors from mining and oil to household goods and telecommunications. Revealingly, eight of these companies have seen the value of their accounts payable – money owed to suppliers – increase over the past 10 years by an average of 82%. Admittedly, many of these firms have also expanded in size during this period. To control for this, the ratio of accounts payable and total revenues has also been computed. In 2008, the value of accounts payable was on average 20% of annual revenues. By 2013, this had risen to 24%, and by 2018 it had reached 28%. This shows that even accounting for the growth of these very large companies over the past 10 years, the amount that they owe to suppliers has expanded at an even faster clip. In pound terms, the value of accounts payable of the top 10 non-financial companies listed on the London Stock Exchange by market cap has increased from £104 billion in 2008 to £138 billion in 2018. FIGURE 12: AVERAGE RATIO OF ACCOUNTS PAYABLE TO ANNUAL REVENUE AMONG THE TOP 10 NON-FINANCIAL COMPANIES LISTED ON THE LONDON STOCK EXCHANGE BY MARKET CAP AS OF NOVEMBER 2019 (SOURCES: COMPANIES’ ANNUAL REPORTS, CEBR ANALYSIS)

0.28

0.30 0.24

0.25 0.20

0.20

0.15 10.0 0.05 0% 2008

2013

2018

It is important to note that accounts payable do not necessarily correspond to late payments to suppliers, since a large share of the amounts owed to suppliers will not be overdue according to the payment terms. Nonetheless, the results above – together with the findings of the SME survey – do point to a pronounced shift in the norms and behaviours towards the payment of suppliers. This shift is characterised by an increased deferral of payments, longer payment terms, and in some cases a higher frequency of late payments.

Financial companies have not been included in this analysis as trade payables are not always reported in a way consistent with major companies in other sectors. The companies analysed are: Royal Dutch Shell, BP, AstraZeneca, GlaxoSmithKline, Diageo, British American Tobacco, Rio Tinto, Unilever, Reckitt Benckiser Group, and Vodafone Group.

26 Q3 2019 REPORT | #SMEhealthcheck

4.4

Potential solutions

When asked to list the factors that have led to making a late payment to a supplier, half (50%) of SMEs in the survey cited late payments from customers. This again points to a snowball effect whereby a single late payment can trigger numerous other late payments by businesses downstream in the supply chain. The growing complexity of supply chains is a key factor behind this trend. The cultural, linguistic and geographical barriers that can exist when firms transact overseas could be seen as heightening the risk of late payments, either through miscommunication or more limited enforcement mechanisms. However, a quarter (25%) of SMEs in the survey stated that they are more likely to receive late payments from UK-based customers than they are from overseas customers, compared to just 11% that said they were less likely. A possible explanation for this is that the frictions associated with transacting across borders lead to an increased diligence and formalisation of procedures that make issues such as late payments less frequent. Administrative factors are another key cause of late payments. The results of the survey suggest that administrative failures on both sides of the transaction can be significant contributors to late payments. A third (33%) of SMEs that have made a late payment to suppliers over the past 12 months stated that this was due in part to a delayed receipt of invoices, pointing to a way in which suppliers can minimise the risk of late payments. Meanwhile, nearly a fifth (17%) of late payers in the survey referred to employee absences or departures triggering delays in the processing of invoices. It is encouraging that the most commonly cited causes of late payments do not relate to fundamental business challenges that prevent firms from meeting their payment obligations to suppliers. Just over one in five (21%) SMEs that paid suppliers late over the past 12 months listed rises in supplier costs or declining revenues as contributing factors, while the share that cited rising staff or rental costs was 14% and 12%, respectively. FIGURE 13: FACTORS CONTRIBUTING TO MAKING LATE PAYMENTS TO SUPPLIERS (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

60% 50% 40% 30% 20% 10% 0%

Late payments from customers

Delayed receipt of invoices

Rise in supplier costs

Decline in revenues

Employee Rise in staff costs Lack of access to absences or external finance departures leading to delays in processing of invoices

Rise in rental costs

The findings above indicate that significant benefits can be unlocked with regards to late payments without the need to transform businessesâ&#x20AC;&#x2122; financial fundamentals through changes to procedures and approaches. Moreover, reforms among a relatively small number of firms have the potential to impact a very high number of SMEs, given how late payments currently cascade down the supply chain.

#SMEhealthcheck | Q3 2019 REPORT 27

One way in which standard payment terms can be reformed is to change the time after receipt of invoice by which customers are required to pay. The vast majority of SMEs (92%) have standard payment terms which they apply to their customers. For each region and nation in the UK, the most common structure is to require payment within 30 days of receipt of an invoice. Nationally, this payment structure is used by a third (33%) of businesses in the survey. Nearly a quarter (24%) require payment immediately upon receipt of an invoice, while 19% require payment within one week of receiving an invoice. It is apparent from the data that more stringent payment terms reduce the risk of late payments from customers. Indeed, Figure 14 shows that among the SMEs that require immediate payment after receiving an invoice, around one in 12 (8%) payments were received late over the past 12 months. The share of late payments rises to 11% among SMEs that require payment within one week of receiving an invoice and 18% among SMEs that require payment within two weeks or 30 days of receipt of an invoice.

FIGURE 14: SHARE OF PAYMENTS RECEIVED LATE OVER THE PAST 12 MONTHS, BY STANDARD PAYMENT TERMS 20% (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

18% 16% 14% 12% 10% 8% 6% 4% 2% 0%

Immediate payment upon receipt of invoice

Payment within one week of receipt of invoice

Payment within two weeks of receipt of invoice

Payment within 30 days of receipt of invoice

Figure 14 suggests that the adoption of more stringent payment terms could help SMEs to reduce the risk of late payments. Over the past five years, 21% of SMEs in the survey have reduced the time that customers have to pay. Among these, more than four-fifths feel that this policy has been either very effective (26%) or somewhat effective (57%) in making sure that their business gets paid more quickly, compared to just 6% that said the change had been ineffective in this respect (see Figure 15 on page 29). 9

It is conceivable that reducing the time after receipt of invoice that customers are required to pay both increases the share of late payments and decreases the average time taken to receive payment. However, the higher frequency of late payments experienced by firms with longer payment periods suggests that reducing payment periods can address both of the distinct but related issues of receiving payment a long time after delivery of a good or service and receiving payment at a date later than agreed or expected.

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FIGURE 15: EFFECTIVENESS OF REDUCING REQUIRED PAYMENT TIME IN ENSURING BUSINESS GETS PAID MORE QUICKLY (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

26%

Very effective

57%

Somewhat effective

12%

Neither effective nor ineffective

Somewhat effective

Very ineffective

Another approach for SMEs to deal with the problem of late payments from customers is to issue fines or penalties to offending customers. A quarter (25%) of SMEs in the survey have over the past five years introduced a fine or penalty for customers that do not pay within the period agreed in the terms of payment. Although the general consensus is that this approach has been successful in ensuring that their business gets paid more quickly – with 40% stating that the policy has been effective compared to 22% who stated it was ineffective – the results are far less resounding than those for the policy of reducing the required payment time.

FIGURE 16: EFFECTIVENESS OF INTRODUCING A FINE FOR CUSTOMERS THAT PAY LATE IN ENSURING BUSINESS GETS PAID MORE QUICKLY (SOURCES: CENSUSWIDE, CEBR ANALYSIS)

11%

Very effective

28%

Somewhat effective

24%

Neither effective nor ineffective

14%

Somewhat effective

Very ineffective

#SMEhealthcheck | Q3 2019 REPORT 29

4.5

Summary of findings

The findings of this chapter highlight the scale and depth of the challenge that late payments pose to SMEs. The vast majority of small and medium sized businesses encounter the issue on a regular basis, with most of these experiencing considerable disruption as a result. Commonly cited impacts of late payments include the depletion of company reserves to maintain cashflow, postponement of investments, and difficulties paying staff on time. There is also evidence of an imbalance between SMEs and larger companies in their ability to dictate when payments are made. Indeed, more than three fifths of SMEs in the survey feel that large companies take advantage of their position as a major customer by making late payments to their suppliers. The growth in the amount that large companies in the UK owe to suppliers also points to a shift towards later payments. In so far as SMEs are less likely to have the ability to set more lenient payment terms than their larger counterparts, this shift towards later payments will have had an overall adverse impact on SMEs due to the various costs associated with these delays in payment. When examining the causes of late payments, it is striking how few can be traced back to business fundamentals, such as insufficient revenues to cover costs. Nearly nine out of 10 SMEs that made late payments to suppliers over the past 12 months say that late payments from customers contributed to this. This emphasises the domino effect that a single late payment can have further down the supply chain. The multiplicative effect of late payments suggests that improvements among a relatively small subset of businesses could have ripple effects throughout the UKâ&#x20AC;&#x2122;s SME community. There is a broad consensus among SMEs that reducing the time after receipt of an invoice that customers are required to pay is the most effective way of ensuring that they get paid more quickly. This is borne out in the current data, which shows that the frequency of late payments is significantly lower among the SMEs with the tightest payment timetables.

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5. CO N CLUS I O N S The health of SMEs picked up slightly during the third quarter of 2019 following a difficult first half of the year. A particularly busy July period breathed some life back into the UK economy, which expanded by 0.3% between Q2 and Q3. The benefits of this were felt by the country’s SMEs, with a significantly higher share reporting an increase in revenues over the past three months. The improved trading environment appears to have buoyed sentiment in the SME community, with slight improvement in both the confidence and lending indicators in Q3. The only indicator to experience a decline last quarter was the employment indicator, as the annual rate of employment growth fell to a seven quarter low. The combination of slowing employment growth and higher demand in the economy also contributed to a fall in the share of SMEs operating below full capacity in Q3. The brightening of the national picture also translated into gains in the SME Health Check Index for the majority of regions in the UK. Yorkshire & the Humber and the West Midlands performed particularly well in Q3, as the increases in the revenue, capacity and confidence indicators observed through much of the country were also accompanied by an acceleration of employment growth. The only regions to see a worsening of the health of SMEs in Q3 were the East Midlands and Wales. The former decline was fuelled by a weakening of the revenue and capacity indicators, while Wales has been hit by a falling number of people in employment.

7.5 T h e S M E H ea l t h Ch e ck I n d e x r i s e s

points in Q3 2019

The SME Health Check report for Q3 is supplemented by a detailed examination of the issue of late payments to businesses. A survey of 1,000 senior SME decision makers finds that late payments from customers are a frequent occurrence throughout the country, with nearly three quarters of SMEs having experienced the issue over the past 12 months. Businesses reported a range of disruptive impacts associated with late payments, including a postponement of investments, difficulties paying staff and the depletion of company reserves. Although the issue of late payments is currently widespread, the results of the survey suggest that reforms to payment terms – particularly through reducing the length of time that customers have to pay after delivery of a good or service – can have a significant impact. Moreover, given the way in which late payments to a single supplier can cascade down a supply chain, improvements in the practices of a relatively small subset of firms have the potential to bring economy-wide benefits.

74% of SM Es paid late by customer s in l a s t 12 m o n t h s #SMEhealthcheck | Q3 2019 REPORT 31

6. M E T H O D O LOGY The SME Health Check Index is designed to measure small business performance and the business and macroeconomic environment within which SMEs operate. The Index includes measures that can be directly linked to SME performance, as well as components that relate to the wider economy. Specifically, the following measures are included: Business costs The Index measures the annual change in costs faced by a typical SME and the main data source for this measure is the Office for National Statistics. Higher costs are associated with a deteriorating business environment as companies will either have to pass these on to their clients in order to protect profit margins or accept lower profit margins in order to secure market share. Capacity The data for capacity comes from the Federation of Small Businesses (FSB) and measures the proportion of SMEs operating below capacity. If firms operate below capacity, this could have negative implications for hiring and investments intentions. Therefore, a higher proportion of SMEs reporting to operate below capacity will have a negative impact on the overall SME Health Check Index. Confidence SME business confidence data also comes from the FSB. The Index indicates how confident businesses are about their short-term prospects over the next three months. Higher business confidence has a positive effect on the SME Health Check Index. Employment Data for this sub-component is taken from the ONS and measures the quarterly change in absolute employment figures. Higher employment figures are associated with an improving macroeconomic environment and may signal improved confidence about future workloads.

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Gross domestic product Gross domestic product figures are taken from the ONS and measure the quarterly percentage change in economic growth. For the regional breakdown, we estimated the quarterly figures based on the previous relationships between a regionâ&#x20AC;&#x2122;s GVA and overall UK GDP growth. Lending For the lending indicator, we used data from UK Finance to calculate the annual change in lending balances. The following measures are included: value of overdrawn balances and value of loan balances. Net Business Creation The data comes from the Insolvency Service Statistics and measures the annual growth rate in the number of registered companies. The higher the growth rate in the number of registered companies, the higher the score. Revenue Data comes from the FSB and measures the net percentage balance of SMEs reporting an increase in revenues.

Following the data collection, we calculate the average of each individual series (such as employment, GDP etc). In a second step, we calculate how many standard deviations a single data point (for example, the employment data point for Q1 2017) deviates from its long-run mean. We then apply a scoring system ranging from 0 to 100. A score of zero is assigned to the lowest observed value while the highest observation receives a value of 100. This means, the more standard deviations a data point is below the mean, the lower its score and the more standard deviations is above the mean, the higher its score. This exercise is repeated for each of the eight indicators. The eight individual scores are then combined with an equal weight to the SME Health Check Index. A summary table of the sub-components can be found below:

Sub-component

Source

Measure

Latest score

Business Costs

Various, including Office for National Statistics

Annual change in business costs faced by SMEs

66 (Q3 2019)

Capacity

Federation of Small Businesses

Net balance of SMEs operating below capacity

59 (Q3 2019)

Confidence

Federation of Small Businesses

FSB Small Business â&#x20AC;&#x201C; Small Business Index

25 (Q3 2019)

Employment

Office for National Statistics

Annual percentage change in employment numbers

66 (Q3 2019)

GDP

Office for National Statistics

Quarterly percentage change 66 (Q3 2019) in gross domestic product

Lending

UK Finance

Annual percentage change in lending to SMEs

61 (Q2 2019)

Net Business Creation

UK Insolvency Service

Annual growth rate in the number of registered companies

16 (Q3 2019)

Revenue

Federation of Small Businesses

Net balance of SMEs reporting rise in revenue

33 (Q3 2019)

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CO R PO R AT E A FFA I RS CO N TAC T D E TA I L S

Christina Kelly christina.kelly@virginmoneyukplc.com 0141 242 3215 07484 905 358 Simon Hall simon.hall@virginmoney.com 0191 279 6090 07855 257 081

@VMUKPLCNews #SMEhealth Virgin Money UK PLC Website: http://www.cbonline.co.uk/business http://www.ybonline.co.uk/business

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Head Office: 30 St. Vincent Place Glasgow G1 2HL Registered Office: Jubilee House Gosforth Newcastle upon Tyne NE3 4PL virginmoneyukplc.com

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