By Denis Baker, CEO, Company Watch, www.companywatch.net

When two major UK retailers, Peacocks and La Senza hurtled over the financial cliff edge into Administration in January, many commentators quite correctly started questioning the impact of excessive leverage on the modern retail business model. Both store chains were carrying huge debts, much of it at penal interest rates. With retail sales and profit margins under ferocious pressure as austerity measures continue to bite into the disposable incomes of consumers, this was clearly unsustainable.

But debt is not necessarily a killer; the issue is how it fits into the mix of assets and liabilities which support and finance a retail company and how the interest burden relates to sales and profitability. Bitter practical experience has long taught that there are certain norms, which are exceeded at the peril of even the most competent or imaginative management teams.

These financial truths apply to all retailers, whether they are big powerful quoted companies or family-owned single site operations. In between are many well developed mid-size businesses, who demonstrate that debts can be part of a success story, provided they are kept under control.

The table below shows the ten mid-size UK retailers in the £30m-£50m turnover bracket with gross debts of £1m or more and the strongest H-Scores® under the Company Watch financial risk assessment system.

All of these businesses are carrying significant gross debts. But once their cash holdings are netted off, their gearing ratios in relation to their net worth (the shareholders’ stake in the company) are, with one exception, well within accepted tolerances. Ultimately, they are using debt to invest in their businesses, but not too much of it.

The other characteristic of this set of healthy debt exploiters is that they are substantially profitable after covering their interest payments, which completes the virtuous circle of sensible financial management, for which all external stakeholders look to reassure themselves that a company is safe to do business with.

It really is very simple. Quite rightly, suppliers, credit insurers, landlords and bankers ask themselves two simple questions: can the retailer pay the interest on its debts and are the lenders taking more than their fair share of the risk? These are key considerations in these difficult times after the global recession and with the threat of a double dip, when liquidity is scarce in the financial sector and risk awareness is at an all-time high.

One hot topic is the relentless march of online retailing, which grows spectacularly each year. Many critics fear for those retailers plagued by the “too many bricks and too much mortar” syndrome, suggesting that online-only retailers have a major advantage without the heavy cost burdens of physical store locations to support and the debts associated with them.

But a brief look at the online-only model suggests that the financial health of its exponents is not necessarily more robust. Of the three examples shown in the table below, two have below average H-Scores, while one is firmly in the Company Watch warning zone with a low score of only 8 out of a maximum of 100. They may be profitable, but the problems are obvious: high gearing or negative net worth. Heavy investment in intangible assets, such as sophisticated software platforms also dilutes financial strength. This is a business model which still needs time to develop and mature.

So the lesson for retailers in Ireland and around the world from the current tough conditions in the UK market is that debt is not necessarily toxic, but it must be kept in balance with net worth and to carry it, the business must be profitable. Some business realities are inescapable and do not change with modern commercial fads or fancy financial engineering gimmicks.