In 1965, two established firms merged and formed the Northern Rock society. A rapid expansion program through various mergers and acquisition initiatives ensured the consolidation of the bank. This was done through the acquisition of fifty three smaller societies by the Northern Rock and one major acquisition. This last was finalized in 1994, and was the merger between the Northern Rock and the North of England Building Society. The society was listed in the London Stock Exchange in 1997. Due to the fact that it was very much relied on financial funds form major US banks, Northern Rock was heavily hit from the subprime crisis. When the liquidity freeze hit the banks, Northern Rock society was affected as major funders withdrew their support for the building society. The bank was successfully granted Government financial support and this resulted in the Nationalization of the bank as on 22nd of January 2008 (Llewellyn, 4). The process was associated with the dissolution of all the member’s shares without any reimbursement. The whole process of nationalization was processed through after two take over bids from prospectors fell through.
In order to make a correct assessment of the present financial situation of Northern Rock and assess what should be done to ensure a better future we should first try to find the reasons why it got it such financial troubles. This is why we have to conduct a financial analysis which will monitor the solvency, cash flow indicators, debt and liquidity measures and ratios, operating performance and profitability indicators.
From the review of the case we can note that there are some significant financial practices that can be deemed at least to be dubious.
Working capital management: liquidity and liability issues
“Working capital management is concerned with making sure we have exactly the right amount of money and lines of credit available to the business at all times. Cash is the life-blood of any business, no matter how large or small. If a business has no cash and no way of getting any cash, it will have to close down. It’s that simple! Following on from this we can see that if a business has no idea of its liquidity and working capital position, it could be in serious trouble.” (Emery, 23)
In this part of the paper we will deal with the liquidity ratios. One of the major problems that Northern Rock had was that it had most of the cash inflow made up from the money it received from money markets. In fact almost three quarters of the liquidity it had were borrowed money. Instead, a normal bank would generate the majority of its liquidity from deposits it gathers from investors or from clients. It was this money that the bank lent to borrowers mostly in the form of mortgages. This meant that the company was relying on debt to finance its lending activities. This debt was coming mostly from the American banks and financing companies. This provided the company with a comfortable source of cash flow but with only one major source and no portfolio diversification.
There was the risk that if the major creditors would find themselves in a difficult position, Northern Rock would follow on their steps. And this is exactly what happened. When the US market was hit by the subprime mortgage crisis many banks and financial institutions found themselves in shortage of liquidity. Thus, they were not able to provide for Northern Rock the amounts they had been providing until that moment. In fact, they were in need of liquidity and immediate cash for themselves. They asked for the return of the debt from Northern Rock but the bank had not much to give them (Llewellyn, 13).
The other important aspect worth pointing out is the very poor asset management. In fact, the bank had the majority of its capital tied with one form of asset: namely mortgage lending. A company has to think very much before deciding to tie their capital in one asset category. What if that category goes blank? There goes your capital with it. And that is what happened. Northern Rock got as far as offering financing options up to 125% of the value of the property. These loans were offered to people who had little (if not at all) potential to repay back. A bad financial practice that impacted heavily the current assets of the bank was the fact that one in five mortgages in the United Kingdom was offered from Northern Rock. This huge expose to the mortgage market made Northern Rock vulnerable to market fluctuations and shocks. Of course it offered very exiting options of short term profitability. Investors rushed to buy debt based asset securities.
But it was also heavily reliable on the ability of homeowners, debt owners, to repay back their loans. When the debt owners in the United States struggled to pay their debts investors got very frightened since they saw the value of these asset securities dramatically fall (Llewellyn, 14). As a result many US banks and creditors stopped lending money to Northern Rock as they fall short in liquidity themselves and saw no more profitability in this business. As a result, Northern Rock saw its main funding cash flow diminish. Thus, it had no more money to lend since it found itself short of liquidity. This situation influenced negatively on the credibility of the bank and its share value fall dramatically. Since it was relying mostly on borrowed money instead of deposits from its clients, the bank had to find some other way of taking a loan in order to ensure enough liquidity. This emergency liquidity option was offered from the bank of England in the type of a bailout in order not to let Northern Rock go bankrupt.
Profitability and solvency
The ability to make profits is what business is all about (Emery, 42). The above description of liquidity and liability are in function of the profitability of the firm. Solvency is the ability that the firm has to repay its debt and meet its long term fixed expenses (Resnick, 126). In the case of Northern Rock, its solvency has been dramatically decreasing. Due to the crisis in the United States its borrowers have been keen in requesting the repayment of their loans. Meanwhile, the general economic conditions in the United Kingdom and the United States have been undergoing various shocks and the ability for repayment of debt owners have been decreasing (Gomez-Mejia, 78). This increased the bad debt voice on Northern Rock’s balance sheets. To get out of this situation it got the 16 billion pound (and increasing) loan, bail out, from the government. This situation made it possible to repay some of the debt it had to mainly US banks and credit institutions. Nevertheless, it did not improve the solvency conditions of the bank. It remained the fact that the financial penalty for Northern Rock from borrowing from the Bank of England was a punitive 7 percent (Llewellyn, 17). The major effect of this financial penalty was that it made Northern Rock uncompetitive and very unattractive for investments in the future from other credit institutions or investors. Thus, the ability to repay its fixed long term debt remained still very low.
This points to the second biggest problem for the bank, its profitability. Due to the diminishing ability of homeowners to pay their mortgage rates, Northern Rock was getting less and less cash back. The property sized as collateral also had declined considerably in value from the time the mortgage evaluation was made. This was a phenomena widespread in the UK and the US alike (Gomez-Mejia, 79).
Thus, the bank found itself in the position where it could not collect the loan rates it had previously budgeted nor could it retrieve the amount of the initial investment made. The combination of bad solvency and low profitability is what forces a business to go bankrupt (Emery, 34).
In conclusion of this financial analysis, it must be noted that the actual business model of Northern Rock has to change at least in two things: it should get alternatives ways of financing its operations and getting liquidity (not only from borrowings on the money market), and should diversity its portfolio in other products than mortgages.
Works Cited
Emery, Dwight. Corporate financial management. Pearson: Prentice Hall, 2007.
Gomez-Mejia, Raul. Introduction to management. New York: Macmillan, 2008.
Llewellyn, Tom. The failure of Northern Rock: A multidimensional case study. London: Oxford Publishers, 2009.
Resnick, Endry. International financial management. Chicago: McGraw-Hill, 2007.