Smaller firms finding it tougher as cost pressure persists

Interest rate rises work by reducing demand in the economy, which on its own does not seem like a particularly good thing given the sluggish rates of growth in the economy overall, but the consensus is that it is a price that needs to be paid in order to bring inflation under control.

Alongside a fall in the headline inflation figure, the Consumer Price Index, there has been a significant easing of producer prices particularly when we compare the growth in prices to the heights seen last summer, with certain producer prices even falling in the latest estimates.

The latest Producer Price Index, which estimates changes in the prices of goods bought and sold by UK manufacturers, showed that output prices rose by just 0.1% in the year to June whilst input prices actually fell by 2.7%. The service producer price index was 4.8% in Q2 of this year, and whilst it remains fairly high, it has slowed in three consecutive quarters since its high of 6.2% in Q3 of last year.

Despite all of this, inflation and energy costs remain chief among business concerns, but both factors are continually being cited less by firms in Scotland as their main concern. Increasingly though, firms are concerned about falling demand for goods and services and interest rates with some notable divergences between large and small firms.

The Office for National Statistics regularly publishes its fortnightly business survey (BICS), which asks a range of recruitment and financial performance questions to businesses across the UK.

The Scottish Government publishes Scotland-weighted estimates for businesses with 10+ employees and a presence in Scotland. In the latest Scottish BICS covering June, the share of firms reporting interest rates as their main concern reached a peak of 6%, with more than 6% of SMEs (10-249 employees) citing rates compared to 4% of larger firms (250+ employees).

The latest UK-wide BICS covering late June/early July shows that across the UK, there are decreasing shares of businesses (of all sizes) with high confidence that they can meet their debt obligations. Back in July 2021, around 54% of firms were highly confident that they could pay their debts however, in July of this year, just over one-fifth of firms had high confidence.

There has been a significant divergence since 2021 between small firms (0-9 employees) and large firms (250+ employees). In July 2021, 53% of small firms reported high confidence in paying their debts compared to around 68% of large firms. In July of this year, just 19% of small firms had high levels of confidence compared to 46% of large firms. Just 14% of hospitality firms felt highly confident in July.

Additionally, the share of firms with no cash reserves has risen from under 10% in July 2021 to 12% in July of this year. Again, circumstances are more challenging for small firms with more than 12% of small businesses reporting having no cash reserves compared to 3% of large firms.

It is worth noting that Scotland has the lowest share of firms citing having no cash reserves across the UK’s 12 regions, and its businesses reported having lower debt-to-turnover ratios than the UK average.

Scotland also has the third lowest rate of firms reporting a moderate risk of insolvency across the UK’s regions. Therefore, overall, financial conditions appear slightly better in Scotland compared to the rest of the UK when looking at BICS.

Despite this, the latest Companies House data for Scotland shows that the average number of monthly insolvencies this year so far (Jan 2023 – Jun 2023) stands at 104. This compares to a pre-Covid (Jan 2019 – Mar 2020) average of 84, and an average last year of 89.

The hospitality sector saw the greatest number of insolvencies in the month of June, and although insolvencies have reduced from their peak in November 2022, they remain high. The construction and wholesale and retail sectors were tied for second for the number of insolvencies last month.

A reduction in the demand for goods and services in the economy, in theory, should feed through to the labour market. However, over the past 15 years, the labour market has had a habit of defying expectations, with employment levels holding much better than other economic data.

In the latest Scottish BICS covering June, businesses were asked if they expect to make any of their workforce redundant over the next three months, with almost 4% reporting that they would. This is a small share of firms, but the share has been rising and has not been this high since the winter lockdown in 2021. The main reason for reducing staff numbers is to reduce costs, and there is a higher share of SMEs seeking to reduce staff costs than large firms.

The majority of SMEs expected to make redundancies in the next month, while the majority of large firms expected to cut their workforce in a 1-3-month horizon.

Whilst the survey data suggests we may see a slight uptick in expected redundancies, whether this will be enough to ease the chronic labour market shortages that have dominated many sectors in Scotland in recent years is still up for debate.

With inflation easing, there will be many firms that can see the light at the end of the inflationary tunnel, and who will be able to chart their way forward with more optimism.

However, not all businesses will be able to sustain themselves in the hope of calmer seas ahead, and the evidence points to smaller firms being more vulnerable to the pain of higher interest rates, which despite the better than expected inflation news, are likely to continue for some time.

We will be publishing our latest quarterly Scottish Business Monitor, a survey of around 500 Scottish firms, next month. So, do keep an eye out for this as we will be digging deeper into how businesses are coping with this challenging and ever-changing economic landscape.

Adam McGeoch is an economist fellow at the Fraser of Allander Institute