When the economy takes a turn for the worse, executives need to embark on two related courses of action. First, they should prepare their companies to ride out the economic storm. Then, they should get ready to take advantage of the recovery that will surely follow. This process requires seven essential steps:
1. Vigorously analyze your business
Get an accurate, up-to-date snapshot of your company’s financial health. Using a spreadsheet, pull together a comprehensive five-year financial history of the business (paying special attention to the balance sheet) and begin looking for trends in key financial ratios. Then, use a benchmark such as the “RMA Annual Statement Studies” to compare your data to other companies in your industry. If your trade association compiles performance metrics for your industry, that’s even better.
When analyzing the data, pay close attention to the following:
- Current ratio
- Quick ratio
- Debt-to-worth ratio
- Return on sales
- Return on assets
- A/R turnover
- Inventory turnover
- Accounts payable days
The direction of these ratios tells you a lot more than the magnitude of the numbers. For example, suppose your sales have doubled in five years but your leverage (debt-to-equity) ratio has gone from 2:1 to 3:1. That may not be a healthy trend. In fact, it could represent a serious decline in your company’s financial stability. If your leverage ratio climbs to 3:1, or above, and operating losses arise, bankers get very nervous—especially when credit is being restricted. The 5 Cs of credit are back—Character, Capacity, Capital, Collateral and Conditions are old school foundations of credit that have become fashionable again.
Next, compare your company’s performance to the industry as a whole, again looking for trend lines. If your industry has reduced leverage and increased profits while you’re going in the opposite direction, that sends up a red flag of possible impending danger.
Search for signs of trouble within your industry. Is there excess capacity? Are too many players offering prices that don’t allow most market participants to operate profitably? Will further price erosion take place if the industry revenues flatten or drop? The more danger signs you see, the more likely that your industry could suffer during the downturn.
You should conduct this financial review and analysis on an annual basis. During turbulent times, it becomes more critical than ever.
2. Identify internal weaknesses.
During good times, companies hire too many employees, acquire too much inventory and extend credit to customers with whom they should not do business. When sales and profits start to fall, theses excesses become painful. Look at every aspect of the business to identify internal areas of weakness, including:
- Overly liberal credit terms
- Too much or slow-moving inventory
- Chasing revenues as opposed to profits
- Increasingly aging accounts receivables
- Declining quality standards
Identify areas to trim before sales go flat, so you can make cuts in a logical, rational manner. Avoid making across-the-board, panic-induced cuts that endanger your core business. To ensure your work force is productive, divide human resources into three categories. “A” performers are motivated, highly skilled in their positions and indispensable under all but the most draconian scenarios. “B” performers are less experienced but “up-and-comers” able to handle new responsibilities. “C” performers are able to keep their jobs only during periods of strong economic growth. The split among these employees is roughly 10%, 80% and 10%, respectively. You and your senior managers know who the “C” performers are–or you should find out as soon as you can. They are the ones who should be released if your business experiences ongoing, or escalating, challenges. For most companies the largest expense is related to employees.
3. Develop a contingency plan.
Review Strengths, Weaknesses, Opportunities and Threats (SWOT) and consider organizing a Profit Enhancement Planning (PEP) team. The PEP team will likely find numerous cost containment opportunities. Talk about the changes you may need to make and when you might need to make them. This should include a combination of tactical and strategic planning that outlines specific action steps your company will implement should profits turn to losses.
4. Create a worst-case cash flow forecast.
First, assume a 10 percent drop in sales and see how that impacts your cash flow. For some companies, 10 percent may represent a conservative worst case. If it looks like your industry will get hit hard, consider a forecast with a 15-or-20 percent decline. Also, recognize that accounts receivables will increase to some degree as customers begin having difficulties paying. In short, get a clear picture of the cash receipts that are likely to be generated over the next 12 months.
Second, calculate the total cash disbursements needed to run the business and to service debt over the next 12 months. Assume that you will have no access to additional trade or bank credit.
Model your numbers to produce a positive cash flow. Make cuts in order to ensure that money going out doesn’t exceed money coming in. Don’t make the mistake of thinking you can increase revenues to cover cash flow shortages. Your marketplace may not let you do so in a weak economy. Further, don’t look to your friendly banker to finance your cash flow shortfall. Instead, focus on cutting costs so you don’t run out of cash should sales take a sudden downturn.
5. Review the terms and conditions of your bank loan agreement.
Go over the specific terms and conditions of your bank loans, making sure there is plenty of room to remain in compliance with all the covenants. Strive for a 10 percent minimum buffer on every covenant in the loan agreement. Don’t get lulled into thinking everything is okay because your banker hasn’t called you in a while. Loan covenants give banks powerful rights and remedies and during tough times they really tighten the screws. Falling out of compliance causes the bank to reevaluate your firm’s risk profile, which requires them to use more human resources to monitor your company’s performance. Your bank won’t necessarily rescind the loan, but it may use the situation to stiffen payment terms and ask for personal guarantees. At a minimum, they will charge you (through higher rates and fees) for the additional cost of doing business with you.
6. Prepare an opportunity-based business plan.
Here’s where you can shift from defense to offense. Companies with a healthy balance sheet and strong cash flow can position themselves to acquire assets and market share from competitors who find themselves in dire financial straits. Such a strategy, however, requires a ready supply of capital, which, in turn, requires a business plan that makes sense to your banker and other sources of financing.
Your business plan should describe not just how you will survive an economic downturn, but also how you will thrive and subsequently rebound. Accordingly, the plan should include a combination of financial data (including your worst-case forecast) as well as a strategy for acquiring new business.
This kind of plan proves to your banker that:
- You understand the current economic environment and are prepared to manage your business accordingly.
- You have the resources to survive the downturn.
- You have a strategy and a plan for going after new business through an acquisition.
Banks are becoming more picky about who they loan money to. If your company is in good shape, you can go to your lender and say, “We understand the business world has turned south, but we haven’t and here’s why.” A well-written plan gets your banker’s attention and support. More importantly, it helps your banker to be your advocate in the loan committee so you can get the credit you need to finance your acquisition/expansion plans.
Despite the current credit crunch, lenders are always searching for great customers. This is a time to improve your position with your current lender by introducing the element of competition. For well-run companies, this is simply a matter of not turning away business other lenders who have been calling on you before.
7. Begin searching for opportunities within the industry.
Pay special attention to competitors experiencing financial difficulties, but don’t rush out to buy companies yet, as valuations tend to remain excessive during the early stages of a recession. Wait until prices become more realistic before implementing an acquisition strategy.
There are also opportunities to lay the foundation for expanding into new products/marketing territories as well as begin searching for outstanding hires in all key functional areas.
Remember: the more things change, the more they stay the same. Economic corrections come and go yet companies continually fail to prepare for them. If you have a well-managed company with good cash flow and a strong balance sheet, there should be no reason for undue alarm. Now is the time to see where you stand, take precautionary measures, and start positioning yourself to take advantage of the opportunities to ride the next economic wave.
Vistage Speaker Ed Freiermuth has more than 30 years’ experience in financing and advising businesses of all sizes. He has worked directly with the CEOs and senior managers of more than 250 companies. As an independent business consultant, he works closely with lending officers, attorneys, accountants, venture capitalists, investment bankers and others seeking to resolve complex financial, marketing and operational challenges.