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The crunch took its toll but British business is set to go

Companies have used the recession to cut inefficiencies and are now in a fitter state to grow, reports Richard Northedge

The prospects for UK companies are better now than at any time since the boom before the credit crunch despite Friday's fall in stockmarkets as investors contemplated the consequences of a hung parliament.

Business has used the recession to strengthen its balance sheets and restore its profit margins. The shock of the slump caused companies to eliminate inefficiencies and they are emerging from the downturn leaner and fitter, ready for the recovery but also able to accommodate a period of austerity as government seeks to restore state finances.

Mike Lenhoff, chief strategist at stockbrokers Brewin Dolphin, says: "For the big blue-chips, the position has improved immensely because of the recovery in the global economy, which has been greater than expected in the US and Asia, especially China. That has been helped by cost-cutting, but the global recovery is so firmly established it is beginning to show in revenues too. The top line is growing more than expected."

UK companies reacted quickly to the downturn in economic growth, cutting jobs, freezing wages, closing unprofitable operations and halting new investment. Capital spending on new plant or research has fallen to its lowest level for 40 years but that has boosted companies' cashflows, making many cash-rich.

Keith Bowman, an equity analyst at investment advisers Hargreaves Lansdown, says: "The majority of first-quarter trading updates have proved reasonably strong. They've benefited from big reductions in interest rates and are using any additional cashflow to reduce debt."

While the public finances are still accumulating debt, the private sector has been repaying its borrowings. They used last year's rising stockmarket to raise record sums in rights issues that have been used to degear balance sheets. Now some companies are looking at how to spend their war chests.

If firms resume their investment programmes, that will put money back into the economy but there is still a reluctance to purchase assets.

Instead, companies are looking to return their surplus cash to shareholders. If 2009 was the year of the rights issue when shareholders sent money to their company, this is the year when they may receive it back through higher dividends or share buy-backs. BAE Systems and Home Retail Group are among major companies to announce programmes for buying in their own shares recently.

Cuts in UK company dividends during the first quarter of the year were the lowest since the start of the recession, according to share registrars, Capita. But after a period of dividend freezes and reductions, the firm is forecasting a rise this year to £59.2bn. That would be higher still if the major banks had not been forced to suspend payments to shareholders and if the weak pound had not reduced the sterling value of dividends paid in dollars by major oil and mining groups.

In the three months to January, 102 UK companies increased or restored dividends compared with only 56 making cuts, helping boost share prices. But the recovery on corporate earnings as profits improve means dividend cover has been maintained despite higher payments.

City analysts know the election must be followed by tough measures as the Government attempts to reduce the budget deficit and repay record sums of debt, but it is braced for severe cuts and believes the benefits will outweigh the short-term pain.

The debate during the election campaign – if the deficit was discussed at all – was whether to act quickly or to defer most dramatic action, but Mr Lenhoff says: "I've changed my mind on this. I think the UK economy is now in a position where it can withstand a dose of harsh medicine – so now's the time to go for it. Initially I thought that the Alistair Darling strategy was the preferred route but now I think it's the George Osborne route that is best."

The analyst even thinks the corporate sector is now strong enough to bear an increase in taxes. "VAT is an easy option. It may curtail spending initially but while people will grumble for a bit, it won't affect their spending habits. And the quid pro quo for an Osborne cold bath is that the monetary policy committee will keep interest rates at these levels for as long as possible, so it won't be any harder for smaller companies to borrow from banks, and banks may be more disposed to lend to companies."

If low interest rates encourage savers to spend, the result will raise consumer demand for companies' goods and services, but they also help keep the pound low, making UK firms' exports cheaper. Although continental markets face their own economic problems and fears of a secondary banking crisis deepen in the eurozone countries, demand remains strong. As the graphic shows, all Europe's big banks are ultimately exposed to each other through their huge debts to neighbouring countries. But Mr Lenhoff says: "Even in Europe some of the big international companies have been doing well and the Americans are doing especially well."

Although the pound fell sharply again on Friday, Simon Ballard, credit strategist at RBC Capital Markets, believes that will help maintain sterling's advantage for UK companies, even if the wider outlook is uncertain. "The failure to elect a government with a solid mandate does suggest that event risk will remain elevated and that the general macroeconomic outlook for UK plc will remain challenged for the foreseeable future," he says. "This situation will persist until such time as we see a potential second general election – or at least until the new government is able to govern effectively."

The City believes the UK will maintain its AAA credit rating, keeping down the government's cost of raising capital and thus not pushing up corporate borrowing costs. Mr Bowman remains cautious, however, saying: "Profit forecasts are moving in an upward direction but so much depends on the economic backdrop and, the reaction of the bond markets because we are borrowing so much. Interest rates affect equity markets."

The stockmarket has anticipated this improvement in sales, profits and dividends, however. "Markets have priced in a good deal of the equities recovery," says Mr Bowman, who nevertheless sees potential for cash-generative businesses that can increase payments to shareholders. "Oil is cyclical but the companies have huge cashflows and telecom companies are resilient to downturn, so offer defensive features," he says.

Mr Lenhoff agrees that investors have priced in much of the improved environment, saying: "The market has had the opportunity to get used to the idea of a Liberal Democrat Party deal and by what's happening in Greece."

But despite Britain's ongoing political and economic problems, UK companies remain attractive for many foreign investors. "Britain has a safe currency and is a home for risk-averse investments," says Mr Lenhoff. And while the pound is weak, investment into the UK is cheap for foreign buyers. That makes UK companies attractive to overseas bidders.

Kraft's takeover of Cadbury and Deutsche Bahn's offer for Arriva could set a trend for other cash-rich foreign companies wanting to buy into Britain just as profits start to emerge from recession. And politicians have more on their minds this weekend than worrying about whether ownership of a new tranche of UK assets are set to go abroad.

Europe's web of debt

Over the past decade, cross-border banking between European countries has soared as the introduction of the euro has brought their economies closer to each other.

The banks and governments of the five big continental borrowers – Spain, Portugal, Italy, Greece and Ireland – owe each other billions of euros and have even bigger loans to Britain, France and Germany.

Although the IMF and the EU are putting together a rescue package for Greece, there are still fears that the sovereign debt crisis could spread to other countries. For example, Greece owes nearly $10bn to Portugal while the German banks have lent about $238bn to Spain and French banks have lent it $220bn. Then there is Italy which is owed $31bn by Spain and has borrowed $511bn from French banks, the equivalent to about 20 per cent of France’s GDP.