This week's release of Japan quarterly balance sheet and p&l survey by the Ministry of Finance reminds us again of how difficult it is becoming to sustain Japan's public finances, even at a time when the corporate sector is managing itself conservatively and well.
The Good News
The quarterly survey gives us the most detailed insight available into how corporate Japan is managing itself: uniquely, one can conduct a Dupont analysis on what amounts to virtually the whole corporate sector. And it is striking how much good news corporate Japan can eke out even in a tough global economic environment. Sales were down 1% yoy in 2Q, and down 0.9% on a 12ma, but operating profits were up 14.2% yoy.
In terms of operating margins, the last year has been a story of a marginally difficult trading environment (COGS/Sales up 0.3pps yoy) offset by much-improved discipline (SG&A/Sales Down 0.7pps), achieved mainly at management level rather than simply by sacking personnel (Personnel Expenses/Sales ratio fell 0.2pps).
Meanwhile, the multiple of sales per employee to total expenses per employee has risen steadily from the recent nadir of 4Q11 and continues to recover. This obviously will tend to sustain labour markets.
The trading environment makes it difficult, but with total assets down 2.2% yoy whilst sales were down 1% yoy, a slow and modest recovery in asset turns is being made. There is evidence of balance sheet discipline: bills and A/R were down 1.1% yoy, whilst inventories were down 5% yoy: together these accounted for a quarter of the fall in total assets.
Finally, the financial leverage ratio (total assets/equity) fell to 2.81 in 2Q12 from 2.86 in 2Q11, and the net debt/equity ratio fell to 62.6% in 2Q12 from 67.5% in 2Q11, with corporate Japan cutting its net debts by Y24.3 trillion during the year.
The net result is that both ROE and ROA have just about been restored to where they were before the earthquake/tsunami/nuclear crises disrupted the economy. A job well-done then? In the uniquely difficult circumstances corporate Japan has been facing, yes.
The Consequences and Cashflow
But in a way, that's the problem, as we can see when we look at the cashflows. With ROE and ROA in recovery thanks to generally improving Dupont ratios, the Japanese economy should be enjoying the cashflow results. And so it is: using change in net debt plus investment in plant and equipment as a cashflow proxy, corporate Japan's cashflow rose 57.1% yoy in 2Q12, and 32% yoy over the 12 months to June, to Y63.0tr.
But the cash is being spent, with investment in plant and equipment up 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.
It is not just rising ROA which is responsible for that cash being spent:
- Japan's capital stock is depreciating away: depreciation rose by 4.7% in the 12m to June. Simply to maintain current levels of capital stock demands re-investment of at least that much. To put numbers on it, depreciation allowances totalled Y8.53tr during 2Q, whilst investment in plant and equipment totalled Y8.3 tr. In the full 12 months, deprecation of Y36.66tr was answered by Y38.73tr in investment in plant and equipment. That investment accounted for 62% of cashflow.
- Nonetheless, the amount of cash on corporate Japan's balance sheet, at 10.7%, is the highest it has ever been since the unwinding of the Bubble year's zaiteku financial games. Return on assets may be low at around 3.15%, but keeping cash on the balance sheet is even less attractive.
The result is that investment in plant and equipment is rising: 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.
But there are plenty of calls on corporate Japan's free cashflows, so that Y24.27tr needs to be put into two contexts.
First, how that net paydown of debt corresponds to movements in the Japanese banks' balance sheets. This will allow us to infer what must be happening to cashflows from the non-corporate sector. Bank of Japan data tells us that in the year to June, bank deposits rose by Y13tr, whilst the loan-book expanded by Y4.5tr – a net deposit inflow of Y8.5tr. But since we also already know from the MOF's quarterly survey of balance sheets that the corporate sector cut their net debt by Y24.27tr (ie, were responsible for a net deposit inflow of Y24.27tr), it must be that everyone else (mainly government and households) cut their deposits by a net Y15.8tr.
This is important: excluding the corporate sector, Japan is running at a savings deficit. The data simply doesn't allow much room for a net flow of savings from the household sector any more.
Second, how does the corporate sector's Y24.27tr in free cashflow compare to the amount of debt the government needs to raise? Here are the sums: in the year to June, the amount of JGBs in issuance rose by Y21.5tr and the amount of short-term financial bills rose by Y4.86 trillion. In all, the government needed to sell Y26.36 tr of its debt. Essentially all of the corporate sector's free cashflow. . . . and then a little bit more.
I have previously noted that Japan's private sector savings surplus looks to be in terminal decline. Indeed, from what we know now, it is rather surprising that it managed even the Y15.72tr surplus recorded in the year to June. What our ramble through the corporate sector's balance sheet reminds us, though, is how precarious the balance now is, even at a time when the corporate sector is managing its operations and balance sheets well during a difficult environment.
It raises the question quite urgently: unless corporate Japan is willing to stop re-investing, and thus see its operational asset base shrink, can we expect it to continue to finance Japan's fiscal deficits? And if not the corporate sector, who?