By Benoît-Mario Papillon, Ph.D., Department of Finance and Economics, School of Management, UQTR

The financial health of companies and the state of the economy: A matter of concern

The fate of companies and the state of the economy are constant concerns for the public. This concern has increased over time.

Historically, basic needs such as food were produced locally, often by consumers who were themselves producers. The urbanization rate at the time was around 5%. Working time was mainly devoted to domestic production, and the time allocated to market production was negligible. Task specialization was limited to a few categories of craftsmen, such as shoemakers, weavers, blacksmiths, and carpenters.

As agriculture became more commercialized and production shifted from artisans to manufacturers, urbanization accelerated. This makes us much more dependent on each other to satisfy our needs, and on the outside world, because Canada's economy, by virtue of its size, has always had to import and export a great deal. There is a French saying that goes, "To make a living you have to sell”; a Canadian version would add “...and you have to export". The level of economic activity has become a general concern, and measures such as the unemployment rate and GDP are used to track its progress. Various measures are used to monitor the financial health of companies, from stock market indices to insolvency statistics.

Our neighbor to the south is currently undergoing a major realignment of both its trade policy and the role of tariffs in its public finances. This development represents a sea change. What do these concepts and metrics tell us about Canada's ability to adapt?

Origin of business insolvency, adapting to change and variations in the insolvency rate

Insolvency originates from credit, which will often be a less restrictive way of channelling savings towards investment needs, and a less costly way of transacting business. Why does a company become insolvent, and thus no longer able to make the payments due under the contracts that define it – as it is sometimes said that a company is a network of contracts?

Financial "causes" (cash shortages, poor equity, etc.) immediately spring to mind. Looking at less direct causes, there are failures of management, and separately, external causes. An example of an external cause in the case of pulp and paper companies was the sharp drop in demand for their products in the early 2000s. To adapt to this major change, companies have turned to the CCAA. However, such events need to be seen in a broader context, in order to understand the role of insolvency proceedings in adapting to change.

Demographic changes are one reason why needs are evolving. Innovation may also change the best means of meeting needs, and the availability of resources can vary as well. Companies are therefore exposed to a variety of changes that require them to adapt. This does not always lead to insolvency proceedings. Conversely, insolvency proceedings are not always the consequence of a failure to adapt. To clarify matters, let's take a closer look at how business insolvency is measured: the insolvency rate.

The rate reported in the OSB's annual statistics indicates, per 1,000 existing companies, the average number of companies that commenced a proceeding under the BIA. This rate has varied at around 1 per 1,000 in Canada over the past decade. Going back to the late 90s, this same rate was higher, ranging from 6 to 9 per 1,000, and declined steadily throughout the 2000s. With a rate of 1 per 1,000, i.e. one tenth of 1%, business insolvency affects a marginal number of companies, and factors that at first glance seem secondary can cause significant variations.

The business insolvency rate is the arithmetic product of two rates. The first is the proportion of the total number of companies that are sufficiently distressed to be insolvent. Let us call this the distressed business rate. The second rate is the proportion of those distressed companies that are undergoing insolvency proceedings. Let us call this the scope of the law, or the business insolvency coverage rate. By multiplying these two rates, the numerator of the former cancels out with the denominator of the latter, giving us the business insolvency rate.

Breaking down the insolvency rate helps us to better understand its variations. The steady fall in the rate over the 2000s was due to a steady decline in the rate of distressed companies, as financial institutions introduced more effective monitoring of commercial debtors. The low rate in certain countries with low per-capita incomes can be explained by the limited scope of the law, which is underdeveloped and not easily accessible. Such a low rate in a country like Japan can be explained by the low rate of distressed companies. Japan was one of the first countries in which the phenomenon of zombie companies, with its negative effects on productivity and employment, was analyzed. The existence of large groups in these sectors enables intra-group transfers that disguise the difficulties faced by certain companies.

Within Canada, there is a marked difference in business insolvency rates between Ontario and Quebec. The Quebec rate is consistently higher, even after adjusting for receiverships being more frequent in Ontario. One hypothesis to explain this discrepancy is that the law in Quebec is broader in scope. Under this theory, the insistence of the tax authorities is a greater incentive for companies in difficulty to use the law to discharge their debts rather than go out of business; and there would be greater accessibility to LIT services for these companies. A second hypothesis is based on the first component of the insolvency rate, that is, the proportion of distressed companies, which would be lower in Ontario. Ethnic groups with high levels of start-up capital and strong family ties are more likely to be found among start-ups, thus increasing the chances of survival of young companies, which account for a significant proportion of distressed companies.

Beyond the factors mentioned above, credit and adaptation to change remain the backdrop to business insolvency. This backdrop also includes the foundations of economic decentralization: private property and free enterprise, with their corollaries of innovation and competition. There was no business insolvency in the highly centralized economies sometimes referred to as socialist, because there was only one enterprise, the state.

Dependence on "To make a living you have to export", pay differentials and adaptation

Canada is an open economy, as revealed by the importance of import-export flows in its GDP. On the same basis, the US was a relatively closed economy until the early 1990s. The Canadian economy became more resilient in the 2000s. The very pessimistic scenarios of the economic effects of COVID did not materialize; there was a rapid recovery in 2021. The impact of the 2008 financial crisis on the unemployment and employment rates was relatively small, compared to the 1990-91 recession and the 1982 recession. This is one reason for optimism in the current environment.

International trade involves costs: 1) natural barriers to trade, essentially the transport and communication costs, 2) political barriers to trade: tariffs and non-tariff barriers (import quotas, excessive health standards, etc.). These costs have fallen significantly over the last few decades, enabling companies to operate directly, or indirectly as suppliers to other companies, in a larger international economy. This is the second reason for optimism, as it has significantly reduced the cost of adapting to change.

To adapt to technological, demographic or geopolitical change, as is currently the case with our neighbor to the south, companies incur expenses to find new business opportunities and adapt their production and products. In an international economy with a greater density of business opportunities, these opportunities are more rapidly accessible and the costs are lower. Canadian companies have become less captive to a particular trading partner, and the large share of Canadian exports held by one such partner implies that the Canadian economy is less dependent on it than was true 40 years ago.

Lastly, the current environment demands that we address what is holding back adaptation to change. Significant pay gaps for comparable tasks between sectors are a distinctive feature of Canada and the United States. To start with, there are the high-paying sectors: heavy industry (metals, refineries, pulp and paper, automotive, etc.) and certain sub-sectors of the primary sector. Over time, these sectors have spawned influential interest groups, which benefit greatly from public policies (subsidies, tariff protection, discounted energy, special treatment on environmental issues, etc.). Secondly, there are the other sectors of the economy, which are often more innovative, and where pay for the same type of tasks is lower. One of the aims of our southern neighbor’s realignment of its trade policy is to maintain these gaps, in a global economy that is less accommodating of such gaps.

Can the Canadian federal system allow us, in the current environment, to start moving away from wage-setting practices that hinder adaptation, while also being inequitable and harmful to democracy? Only time will tell, and LITs have a front-row seat to the future.

LITs will be called upon to correct the effects of such practices after the fact, as was the case for the pulp and paper sector some fifteen years ago. Alternatively, they will be called upon more and more to liquidate companies in the more dynamic sectors of the economy, if the political choice made in Canada is to protect more of the traditional sectors that are so dear to the current U.S. government, to the detriment of the more dynamic sectors.

Adapting to change is no trivial matter. Any given change, such as the kind now coming from the U.S., can be managed in a decentralized way by an economy capable of adapting itself. Otherwise, it requires centralizing government action, as was the case with Covid. Such an action, which can temporarily suspend business insolvencies, also suspends the ability of such proceedings to distinguish healthy companies from unhealthy ones. That ability is what allows us to distinguish external causes from internal responsibilities. This is because free enterprise and personal responsibility - exemplified by the ant in the fable of the ant and the grasshopper - are two sides of the same coin we call economic decentralization.