At a time when financial restructuring has become the dominant focus, it is all too easy to ignore the underlying operational issues that made it necessary in the first place.

Although the Honourable East India Company, founded in 1600, is often recognised as the first modern business entity, it may have been the Ancient Egyptians who first created organisations that were recognisably similar to modern businesses. The building of the pyramids is perhaps the ultimate example of what can be achieved with operational structures and processes that are fit for purpose.

However, as businesses evolved into their modern forms, it became necessary to structure a company in a suitable manner not only operationally but financially, to take account of the many legal and financial reporting requirements. Throughout the twentieth century, different management schools of thought debated the best way to manage and structure a business operationally, while the financial structure of businesses remained relatively simple.

The concept of financial restructuring was generally only considered an occasional activity for major corporate bodies, until the M&A boom of the 1980s saw the widespread growth of ‘financial gimmickry’ to improve a business’s situation. Since then, and particularly in the last ten years, there has been extraordinary growth in the variety of complex and inventive debt and equity instruments available. Such instruments, combined with high levels of market liquidity, provided opportunities for all sizes of business to undergo regular financial restructurings, each one often resulting in a more complex balance sheet than the last.

Heads in the sand

The ease with which many businesses have been able to obtain new money to rectify difficulties in their balance sheets and cashflow has led to problems. Rarely did they, or the other parties involved, examine why the need for the financial restructuring had occurred. To use a building analogy, some businesses were re-plastering the walls to hide the subsidence cracks.

The need for financial restructuring is often just a symptom of wider problems that can stem from operational issues. Hence many businesses have found themselves doing it repeatedly, only to find themselves requiring more money. Suddenly, this money is less easy to get hold of. It is to be hoped that the shortage of easy money will now force such businesses to take their heads out of the sand and think operationally. Unfortunately, many are now finding that, although previous refinancings may have afforded them ample time and options for restructuring the operational side of the business, they now have far less room to manoeuvre.

A three-sided problem

Sadly, all parties – management, lenders, advisers – must share the blame for this predicament. Management have found it too easy to accept ready cash to fill a financial hole and continue spending on big expansion plans, some of which may have been entered into without ensuring the business was operationally sound. At the same time, lenders often set targets for their front line sales and customer relationship staff based primarily on selling new lending and other products. Problems arose from ever more relaxed lending criteria, with little incentive to monitor customers that were struggling to repay. Advisers, meanwhile, could earn substantial fees advising on balance sheet restructurings and refinancings, and were able to satisfy clients without pushing the much harder sell of examining and advising on the day-to-day running of the business.

Although financial restructurings and refinancings will continue to be necessary, it is essential that, as they occur, any underlying issues on the operational side of the business are also addressed.

Example: Roped together

Two associated companies share common ownership and management, but are not a part of the same corporate group. One company operates within the transport industry and has proved very profitable with a negligible amount of debt.

The second company is in construction, in particular the building of houses using pre-fabricated walls, roofs and floors. This company was not so successful and has invested heavily in new technology and products funded wholly through debt. Having already gone through a number of refinancings, this medium sized business was (like many companies at the present time) highly leveraged, with multiple levels of debt and all of its tangible assets financed.

The senior bank was becoming concerned that upcoming repayments would not be met as the company was failing to meet its forecasts. Another financial restructuring was needed – but this time no further debt could be raised and the equity was not an attractive proposition.

As a result, a plan was conceived for the associated company to borrow in order to lend to the construction company. This solved the immediate financial concerns, but clearly the construction company had underlying operational issues which had led to an unsustainable level of cash consumption. Like so many businesses that turnaround advisers come across, it was too turnover focused and had seemingly forgotten the need for profit and value creation. Management tried to justify this as a ‘development phase’.

A comprehensive review of the business led to the consolidation of two factory premises into one, management changes, the initial suspension of all R&D activity, and a comprehensive costing review which resulted in hard-nosed negotiations with both supplier and customers to improve both cashflow and profit margins.

Without such measures, particularly with a worsening outlook for the industry sector, the company would almost certainly have failed and dragged the associated company down with it. Such measures could have been implemented much earlier if any of the parties involved had recognised the need to address operational issues alongside implementing any financial restructuring. This would have avoided the need for the associated company to risk its own business by borrowing heavily to support the construction company.

Turnaround solutions

The process of operational restructuring and turnaround can be adapted to any given set of circumstances to focus on a specific area, or examine the business in its entirety. It often consists of four main stages:

• Emergency stabilisation
• Diagnostic
• Reporting and structuring
• Implementation and monitoring

Both the first and fourth phases are likely to involve financial restructuring.

Financial restructuring should be a tool used to fit the operational needs of a business, which should in turn be focused on profitability and value creation. It should not be used as a stand-alone remedy to mask the underlying causes of a business’s failure to operate efficiently and effectively. It only treats a financial symptom of such failure.

A financial restructuring can often be the first, essential step on the road to securing a business’s long-term future. But it can only be successful if it complements the operational side of the business that is itself structured to be fit for purpose. There is certainly no shame in seeking advice on operational issues within a business. If businesses are to survive hard times, it is up to all stakeholders, including lenders and advisers, to encourage a culture in which operational restructuring and turnaround can thrive as financial restructuring has done in the recent past.

For a confidential discussion of any corporate recovery and insolvency issues, please contact partner Philip Long, head of Corporate Recovery and Insolvency: philip.long@uk.pkf.com or tel 020 7065 0330.