It’s official. We’re in a UK recession for the first time in 11 years. The economy shrank by 20.4% over the last quarter, the biggest drop in gross domestic product (GDP) on record.
Firms are grappling with tough market conditions right across the FTSE. Declining revenues, higher debt, and lower productivity are the norm for many.
However, by watching the market for high-quality companies at discounted prices, investing opportunities will emerge. And by looking for companies with strong balance sheets, low debt, and good cash flow, you can thrive by investing during the UK recession.
Here’s how you can identify them.
A strong balance sheet
The balance sheet is essentially a photograph of what a firm owns (assets) and what it owes (debts) at any one point in time.
A strong balance sheet will have a ‘current’ ratio of around 1.5 to 2.0. The current ratio determines the relative levels of short-term assets and liabilities. If this ratio is too high, a firm may be accumulating cash. If it’s too low, a company may struggle with its short-term liquidity needs.
The quick ratio is an even more conservative liquidity estimate because it only considers assets that are cash-convertible. To calculate it, subtract the inventory and pre-paid expenses from the current assets and divide this net figure by the current liabilities. The ideal quick ratio figure is 1 or more.
These ratios are only guides, but they can help to determine the strength of balance sheet liquidity in the short term. But bear in mind that all ratios will vary per industry.
Regardless, companies with strong balance sheets can withstand tightening of credit conditions and better manage their debt.
Another useful number to know is the debt-to-equity (D/E) ratio. D/E shows what is owed against what is owned. Usually, the lower this ratio the better, but if a company has no debt, it cannot offset it against tax, potentially lowering profits.
However, companies with high amounts of debt will likely make large interest payments, increasing the debt-to-equity ratio. In a recession, investing in highly leveraged companies is risky because they’re more likely to fail. Low debt, and a lower debt-to-equity ratio of 1.0 to 1.5, is best.
Good cash flow: essential to beat a UK recession
Lastly, a firm needs to be good at generating cash to see it through the bad times.
The debt service coverage ratio (DSCR) determines whether a company’s income is enough to pay its debts. Usually, a higher ratio of 1.15 to 1.35 is better. Calculate it by dividing net operating income by current debt.
However, cash may have been received by selling assets or taking on more long-term debt. Calculating free cash flow (FCF) in addition to the DSCR helps determine real profitability.
FCF is the cash left after the firm has paid for dividends, debt, or stock buybacks. It’s what’s left over to invest or return to shareholders. A positive FCF is a good sign.
In addition to the above, some industries will be more recession-resistant than others. For example, utilities, discount retailers or consumer staples will be safe havens for many. But this may push up share prices in the short-to-medium term.
Regardless, for a vigilant investor with an eye on the right industries and metrics, the UK recession really could provide opportunities to find high-quality companies at discount prices.
Rachael FitzGerald-Finch has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.