By Max Clarke

The mood of optimism with which British financial directors (CFOs) entered 2011 has weakened, according to the latest Deloitte CFO Survey.

High levels of inflation and concerns about the effects of fiscal tightening seem to be weighing on sentiment. CFOs remain cautious about the sustainability of the recovery, attaching a 29% probability to the chance of a double dip in the economy — up from 27% last quarter.

On average, CFOs expect the UK fiscal squeeze to reduce UK corporates’ potential profits by 7% this year. 83% see the fiscal squeeze reducing their companies’ 2011 profits.

This quarter’s Survey of 137 large companies,including 46 of the FTSE 100 finance directors,found that CFOs remain, on balance, positive, but optimism has dropped back to the lowest level in two years.

Lower levels of optimism have not, however, dented attitudes to risk. On the contrary, risk appetite has risen to the highest level since the CFO Survey started in Q3 2007, with 41% of CFOs saying that this is a good time to take risk on to their balance sheets. Risk appetite is strongest among the largest companies.

Margaret Ewing, Deloitte partner and vice chairman, commented: “Reduced optimism among finance chiefs seems to be influenced by external events, such as conflict in the Middle East and the earthquake in Japan, and movements in financial markets. By contrast, high levels of risk appetite seem to reflect longer term judgements and more positive views on corporate balance sheets, the opportunities available to companies and financial conditions.”

In a sign of the growing confidence in the strength of balance sheets, opinion among CFOs has shifted towards raising leverage for the first time since 2008. Large corporate are also pursuing growth strategies — with expansion being the top priority for CFOs over the next 12 months.

Making acquisitions and raising capital expenditure are increasingly popular strategies. For now at least, financial conditions are favourable for larger companies. Credit availability for the largest UK corporate has risen to the highest level since the Deloitte CFO Survey started in 2007. Finance directors see bank borrowing and bond issuance as being as attractive as they were in 2007, well before the credit crunch.

Ian Stewart, Deloitte chief economist, commented: “CFO optimism has taken a knock, but large corporates do expect revenues to rise over the next 12 months and are increasingly seeking growth opportunities through expansion, raising capital spending and acquisitions. However, with inflation at current levels, profit margins are unlikely to expand at the heady rates seen in 2010.

“While corporate profits have rebounded strongly from their lows, high inflation and the prospect of higher interest rates may limit the scope for margin growth from here. CFOs are less confident than the Bank of England that inflation will decline over the next two years. Most CFOs think there is a less than even chance of inflation falling back to its 2.0% target in two to three years.

“The most widespread concern about inflation — cited by 40% of CFOs - relates to the way in which it raises input or raw material costs, and thus threatens margins.

“Finance directors also believe that the first rise in UK interest rates is in sight, with two thirds expecting the Bank of England to raise rates by September. In total, 86% of CFOs surveyed expect UK interest rates to rise by the end of the year. Just 4% expect base rates to stay at their current level of 0.5% for more than a year.”