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A hollowed out tree stump
istock_hollow-tree_Martin Wahlborg

Hollowed out firms make risky distributions to shareholders


Richard Murphy interrogates the increasingly common practice of hollowed out firms, where entities have over-distributed profits which leaves weak and vulnerable balance sheets supported by loan financiers who often have too much to lose by pulling the plug.

2nd Mar 2022
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Last year I published a report with colleagues at the University of Sheffield and Queen Mary University of London on what we describe as the phenomena of ‘hollowed out firms’. This built on previous research which also included colleagues from Copenhagen Business School.

We examined the investment and productivity performance of large UK listed firms who make outsized, and potentially financially risky, distributions to their shareholders.

The research

To undertake our research we examined accounting data from all 182 companies who were members of the FTSE 350 index in every year between 2009 to 2019. Those companies were ranked according to the ratio of their dividends paid plus share buyback expenditure to their declared net income after tax attributable to shareholders over that period.

Having prepared the data the companies were then grouped into quintile groups. The investment and productivity performance of those quintile groups was then analysed. Details of the companies in each group are in the report.  

The results were surprising. This accounting data shows the quintile with the highest dividend and buyback distribution to net income ratio paid out on average 178% of their net earnings after tax over the decade reviewed. Admittedly losses had an impact on this quintile on occasion, but the ratios were still at levels that were much higher than we expected.

The next quintile distributed 88% of their net earnings, on average.

Significantly, these two quintiles, reflecting 40% of the companies surveyed, represented 60% of the market value of the sample of 182 companies.

In contrast, the lowest quintile ranked by their distributions ratio, or 20% of companies surveyed, distributed just 37% of their earnings, on average. They represented 7% of the sample by market value. These initial findings are summarised in this table:

Initial findings summarised in a table
Data source: Thomson Refintiv database

How did the high distribution companies perform?

In itself this finding was significant, but what we then sought to establish was how those high distribution companies performed in terms of investment measured by capital expenditure per employee and productivity measured by sales growth and value-added growth per employee.

The aim was simple: what we were seeking to establish was whether these companies were putting more emphasis on financial engineering to manufacture dividends than they were on actually generating profits by investing in their trading activity.

The research found that the highest distributing companies performed worst on real capital expenditure per employee growth and worst on sales and value added per employee growth as the following charts, organised by quintile demonstrate:

Growth in real capital expenditure per employee

Growth in real sales revenue per employee

Growth in real value added per employee

We found broadly similar trends over a number of other indicators. For example, average margins and average return on capital employed ratios were also lower for the highest distributing firms over the decade:

Average net income in sales

At the same time those companies that distributed most or all of their earnings also appeared to carry greater balance sheet risk. Gearing is a measure of the long-term debt of a company expressed as a ratio of debt to the shareholders’ funds invested in the entity. The more debt there is, the higher the risk in the company.

In 2019 these ratios for the 182 companies surveyed were as follows, ranked by the same quintile groups:

Long-term debt to equity

It is generally accepted that the higher a company’s gearing ratio the risker its balance sheet is. It is apparent that the companies paying the highest level of distributions also appear to have the highest levels of risk within their balance sheets. 

Risk of borrowing

Our work also investigated another risk, which is that the risk of borrowing increases if the borrowed funds are used to acquire assets which are more speculative in nature. Goodwill is arguably the most significant speculative asset on many balance sheets because it is arguably more prone to irregular accounting impairments.

Our research shows that the highest distributing companies also have the highest amount of goodwill relative to shareholder equity on their balance sheets, leaving them more exposed to impairment risks:

Goodwill to shareholder equity

The consequence is that the companies with the highest dividend distributions are also those with the greatest risk of goodwill impairments.

What the research shows

Our research suggests a number of things. First, there is a sizeable minority of large UK firms who distribute more to shareholders than they generate in net income. This suggests that we now have a financialized corporate world where financial engineering and creative accounting play an enlarged role.

Second, there is a growing dislocation between the ‘firm identity’ of a company, ie its social and technological activities and relations, and its ‘corporate identity’, ie its reporting and legal personality, with the latter being prioritised by some boards to pay rewards in excess of those that the underlying entity appears capable of supporting.

Third, this focus in financial engineering appears to significantly increase shareholder risk.

Fourth, if shareholder returns can be met from financial engineering and creative accounting practices, as this implies, this may divert corporate efforts towards representational rather than operational concerns, crowding out investment-led productivity-enhancing strategies. This might help explain the long-term decline in UK productivity.

Fifth, those seeking long term value in stock markets may need to be aware of these behavioural differences which the research shows can exist.

More awareness is needed

Given the significance of stock market companies for so many parts of the economy and for pension saving we suggest some serious attention needs to be given to our findings and what they might mean for the future returns of UK companies. Some of those issues are addressed in further papers that Prof Adam Leaver and I have prepared.

One looks at the need for robust capital maintenance rules in the UK. Another asks how it might be that companies can generate excess profits for distribution within their group structures. A third suggests how distributable reserves can now be estimated by companies that have failed to do so in the past, contrary to the requirements of UK company law, in our opinion. All might be of interest to AccountingWEB readers.

Replies (6)

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By Hugo Fair
02nd Mar 2022 17:49

"This suggests that we now have a financialized corporate world where financial engineering and creative accounting play an enlarged role" ... surely hardly the surprise that author claims.

Financial engineering is antithetical to the foundations of basic accounting principles, so wouldn't be used except where a degree of subversion is intended. And once started, why not push the boundaries a little more? This is just another aspect of short-termism and unbalanced rewards - I could go on.

Thanks (1)
By paulwakefield1
03rd Mar 2022 08:38

A fascinating read. An interesting follow up would be a study of the companies that were not in the FTSE 350 for the whole period (at least 168 and presumably a fair bit more). How many fell out because they were adopting the same policies as the top quintile?

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By JackGrover
03rd Mar 2022 12:07

It would be interesting to see analysis against other factors, eg where in their life cycle are these companies, and what is the distribution of industries across the quintiles. There is no comment on whether the quintile 1 companies with greater gearing & payouts are in fact able to access these higher levels of debt because they have lower inherent business risk and are therefore deemed able to bear greater financial risk by lenders. Or are the quintile 4 and 5 companies ones earlier in their life cycle, in growth markets and therefore more easily able to grow revenue, but therefore inherently more risky and therefore unable to gear to such an extent. Or are they ones in fixed asset intensive businesses and accordingly need more capex.

Without a full consideration and disclosure of context and causality I wonder how firm the conclusions are.

Thanks (1)
By AndrewV12
04th Mar 2022 11:20

Extract above
'We examined the investment and productivity performance of large UK listed firms who make outsized, and potentially financially risky, distributions to their shareholders.'

When I read the heading 'Hollowed out firms make risky distributions to shareholders' I thought the article related to crappy little company's on AIM, I had no idea it related to large Uk listed Companies.

A good thorough article by Richard.
Please tell me my crappy Bank shares are going to go through the roof in 2022 :).

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paddle steamer
07th Mar 2022 13:54

IMHO the more important thing re listed companies and risk to their dividends is cashflow rather than earnings. You mention companies with high levels of balance sheet goodwill distributing greater earnings proportions, but of course if said earnings are after amortisation their ability to shed cash may be far higher than their reported earnings. (Think say mature tobacco companies)

Now of course there is risk, these are old beasts with limited future growth, but frankly I suspect I would generally feel safer with an uncovered dividend from a cashflow positive beast than a lower dividend from an over investing younger entity (remember markets often punish companies if they carry too much cash and if they do not distribute directors have been known to buy baubles they never should have touched)

To me surely the warning is more a dividend being paid combined with increased borrowings rather than necessarily being in excess of reported earnings.(though it may be an indicator)

I used to invest following a HYP approach though as I have got older I have tended more to ITs instead, high yield always stuck me as chasing the incorrect indicators but of course calculating cashflow per share can be tricky, especially re capex adjustments.

(I have poor regard for the reporting of profit so all this may just be my latent prejudice)

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GTA Accounting
By gtaaccounting
01st Apr 2022 15:29

Without a full consideration and disclosure of context and causality I wonder how firm the conclusions are.

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