Accounting for failure

What did we learn from the Wilko enquiry?

Yesterday saw a group of MPs (the Parliamentary Business and Trade Committee) pull together a set of experts and witnesses to discuss what happened when the retailer Wilko failed earlier this year. I’ll confess I didn’t tune-in with high expectations - previous experience is that these sessions can often involve a lot of preening for the cameras and little actual insight, but this session was a good deal calmer and more forensic than I was expecting.

Many of you in the Moving Tribes gang are actually here because of the last article I wrote about Wilko:

Besieged

In that piece, I tried to give something of an “insider’s view” of what it is like in a business just before it goes into administration. This post offers an opportunity for a slightly less close-up perspective, on what a catastrophic failure like Wilko can teach us about business and about the legal and regulatory environment in which business operates.

Just like in Besieged, though, I’m going to resist getting too personal about the people involved yesterday and I’m going to resist offering too many easy sound-bites about just how the administration could have been avoided. Gather any 2 retail observers and you’ll get 3 opinions about that and the reality for any specific business is always more complicated than it appears from the outside.

Instead, I want to focus on some of the larger lessons that emerged from this morning’s discussion and explore what they mean for the rest of us. Here are a few of those:

Lesson 1 - be careful not to rest on past successes

It was a theme of my last post on this topic that the Hemingway quote about how bankruptcy happens (gradually, then suddenly) is very true. The former Chair of Wilko this morning was at great pains to keep coming back to “we were fine until 2022, then it all went wrong” but the reality is that many of the seeds of the business’s troubles were planted long before that. Long leases, high rents, stores in the wrong places, availability issues and an ill-advised attempt to move up-market and away from being a traditional discounter have all been highlighted by various observers.

Whatever your view on the strategy the business should have followed, it was clear that even pre-pandemic this was a business that was making almost zero operating profit on more than £1.5bn of turnover, which is not a great recipe for success.

So why would the Board at Wilko have thought that all was well even as late as 2021? Well, basically because they had plenty of cash. A conservatively managed business with relatively little debt, it closed Jan 21 with £107m of cash at hand - by anyone’s measure, a strong balance sheet.

But the cash you have on your balance sheet is, of course, a measure of successes past. What’s happening in your business now is the determiner of whether that cash balance goes up or down. By Jan 22 the figure was only £58m and the subsequent administration tells us that the figure only went down from there.

What is the lesson there for the rest of us? It’s too easy for a business which is losing saliency with its core customer audience to tell itself “yes, but we still have a really big market presence” or “we still have a strong balance sheet and lots of assets” when those, just like Wilko’s cash, are historical assets which can quickly be eroded away. Paying attention to more forensic measures like market share growth, customer attitudes, purchase frequency and basket size is a better way to keep your team honest about whether things are really as rosy as they appear.

Lesson 2 - Cash is king (until it’s gone)

How, though, can such a significant war-chest be eroded so quickly? Here the problem is that poor trading is only one of the ingredients (and certainly one that happened to Wilko). The other big drains on cash cited in the discussion at Parliament included:

• A big squeeze on working capital as credit insurers cut cover and suppliers demanded payment up front rather than after the fact.

• A decision to continue trading during lockdown rather than utilising government support like most retailers

• A disastrous investment programme in warehouse systems

• And finally, the withdrawal of lending facilities and the failure of an attempt to create a new one.

All of these drain the cash position of the business and cumulatively they are fatal. Gradually, the business ended up chasing emergency lending and investment options, but because it was losing supplier support it never quite managed to achieve the virtuous circle of “new investment calms suppliers, calmer suppliers stop demanding cash up front and that makes investment easier to get”. It is a huge credit to the team leading the business at the very end that they got extremely close to pulling that off, and a great tragedy that they didn’t quite make it.

The lesson for the rest of us - as ever, it is that the cashflow is the most important financial statement. Pay huge attention to possible movements (good or bad) in working capital, watch out for big capital investment bills coming due and keep a rolling cashflow projection in your pocket. A weak P&L is embarrassing, but a weak cashflow is fatal.

Lesson 3 - The Going Concern Conundrum

Some of the most interesting discussion yesterday for us business nerds was about the concept of “Going Concern”. In a nutshell, one of the tasks for a Board of Directors when signing off the accounts is to agree that those accounts should be prepared on a Going Concern basis - in other words, should the way that various assets and liabilities are valued be done on the basis that the business will continue to be here for the foreseeable future.

That’s an important call because if the answer is ‘no’ then the valuations of those assets and liabilities would be done on a very different basis (essentially as if you were about to have a liquidation fire-sale) and therefore the accounts would look very different.

For most businesses, in fact, they’d look entirely unviable. The result of that is that the “Going Concern Test” that directors apply is a pretty existential one - if you decide you pass the test, your accounts (however ugly they look) are deemed a true and fair representation of your business, but if you decide you can’t pass the test, you are effectively declaring the business insolvent.

This becomes a very challenging process when a business is in financial difficulty. If you fail to throw in the towel and continue trading when you shouldn’t then you are “wrongfully trading” and the directors of the business can get in a lot of trouble. But if, on the other hand, you apply an overly conservative definition of what ‘Going Concern’ means then you risk killing off a business that might otherwise have been just fine, with all sorts of costs for suppliers and employees.

Many businesses, and certainly almost all retailers, exist in a kind of ‘circle of confidence’ where as long as suppliers, lenders, customers and landlords all believe the business is sustainable then they do business on sensible terms and all is well. But as soon as one or more of those stakeholder groups takes flight, then they start to demand payment up front and as we’ve just seen, cashflow becomes a problem. In this sense, businesses require confidence from everyone around them in their viability, and the Going Concern test is a key measure of that.

Quite a lot of the discussion yesterday therefore revolved around the role of the auditors of the business, whose role is to be independent and effectively sign off that the accounts are ‘true and fair’.

There is definitely some interesting food for thought there - the auditors themselves pointing out that they had been quite clear in their covering letters on the accounts that there were material risks for the business and that (latterly) it didn’t have the financial resources it was likely to need to survive.

If there is a lesson there for the rest of us, it is to read those audit letters carefully, because in a very British fashion they tend to read as very under-stated even whilst they are telling you that there is a real problem in the business.

For the MPs though, there is plenty to think about from a regulatory point of view. As one of them pointed out, sophisticated suppliers and lenders will be reading a business’s accounts closely and picking up on those clues, but smaller suppliers, employees, pension holders and other stakeholders are much less likely to do that and have many fewer choices even if they do.

Lesson 4 - What can Government do?

And that reference to pensions opens up another area where the Wilko story offers some interesting food for thought for the government. It is clear that there is a problem with the Wilko pension fund being under-invested and there will be (justifiably) a lot of discussion about whether those who benefited from big dividends from the business over the years should have some responsibility to close that gap.

But there are other, more systematic issues that this exposes too. Just like the Going Concern issue, pension liabilities are valued differently if the parent funding business is solvent than they are if it is bust. As a result, the Wilko pension fund is now showing a much bigger deficit than it was when the Board of Wilko used to monitor it in their regular meetings - should businesses take a more prudent approach to managing pension deficits, and what would be the impact if they did?

And when things go wrong, there are choices too. The MPs yesterday heard, for example, that the pension fund is a pretty low-ranking unsecured creditor when a business goes under - so the VAT bill, for example, gets paid in preference to the pensioners. They were invited to consider whether that is a fair and sensible ranking of an insolvent business’s debts and that is well worth considering.

What’s next?

The Wilko story will run and run. There are too many tempting ingredients - a brand beloved by millions of customers, a colleague base who were loyal to the brand and to each other to the very end and wealthy family shareholders who are likely to be painted as the villains of the piece.

It is, though, slightly fruitless for the rest of us to try to diagnose what could or should have happened in that business when we will only ever have part of the story.

Much more useful, then, to try to learn the wider lessons from the Wilko failure, and there are plenty of those. For the MPs on the committee and for the Government there are lessons about the management of corporate pension funds, about the complex and often overly cosy interplay between advisors, auditors, accountants and insolvency practitioners and about how they can best support the future of the High Street.

For the rest of us, there are lessons too. Don’t leave it too late to take corrective action if your business is losing ground versus its competitors. Don’t allow your Board to be in denial about what needs to be done. And above all, stay focussed on your core customer base - my suspicion is that the loyal Wilko customers and their exceptional store colleagues had a pretty good idea what was going wrong all along.