Managing In A Down Economy

After a prolonged period of growth it is not unusual for economies to take a turn for the worse. However, there are several measures you can take to prepare your company for recessionary conditions. And if your balance sheet and cash flow are strong when the downturn comes, you will have a great opportunity to acquire assets at discount prices.

Preparing for a downturn

There are precautions you can take to ensure that your business suffers as little as possible during an economic slowdown.

• Set conservative budgets so that you don't haemorrhage cash.
• Build in as much financial liquidity as possible.
• Work with your lenders to get as much credit as possible, striving to maintain a 10% margin for error with your financial covenants.
• Prepare a comprehensive cash flow forecast that includes best and worst case scenarios.
• Scrutinise every job in the company to determine which are essential to the core business and which can be cut if necessary.
• Once you have these defensive strategies in place, start thinking about how to position your business to take advantage of the next economic upturn.

Understanding economic cycles

To ensure that your company can make the best of economic conditions, whatever they are, you need to understand economic cycles so that you can stay ahead of the game.

Every economic cycle consists of four distinct phases:

A (Advancing)

B (Best)

C (Cautionary)

D (Dangerous)

Phase A (Advancing)

The economy has hit bottom and is just beginning to come out of a recession. Trend data for sales, orders, inventory and so on continues to look dismal, and may still be trending downward, but leading indicators point to a recovery in the near future. During this phase, you should shed your defensive tactics and begin ramping up for the recovery.

Phase B (Best)

The economy runs progressively higher than the previous year and trend data climbs at a sharp rate. This is the time to:

• take risks
• budget for prosperity
• implement aggressive expansion programmes that you planned and staffed for during Phase A
• roll out new products and services.

Phase C (Cautionary)

The economy begins to weaken but hasn't turned overtly negative. In most companies, performance continues to run above previous years' levels but growth becomes harder to achieve. Instead of pursuing growth, in Phase C you should:

• stop hiring
• avoid long-term purchase commitments
• tighten requirements for capital equipment expenditures
• weed out inferior products
• begin implementing cost-cutting measures.

Phase D (Danger)

The economy has turned overtly negative. Data trends have fallen below previous years' levels and are actively declining for most businesses. During Phase D you should:

• manage for survival rather than growth
• pay extra attention to cash flow, margins and key financial ratios
• tighten up on accounts receivable
• adopt a defensive position vis-à-vis market and pricing pressures.

How to benefit from a downturn

To take advantage of economic downturns, you need to be able to predict with reasonable accuracy when the economy will move from one phase to the next. You can do this by:

• conducting a quarterly and annual rate of change analysis for your company
• comparing your company's rate of change to that of the economy as a whole
• monitoring key macroeconomic indicators.

Your company's rate of change

To conduct the rate of change analysis, use a spreadsheet to aggregate your sales data into separate three-month and twelve-month rolling totals.

To determine your quarterly rate of change, divide the sales total for the most recent three months by the sales total for the same three months from the previous year.

The annual ratio works in the same way, except that it involves a rolling total for twelve months rather than three.

Ratios above 100 generally indicate favourable economic conditions. However, the direction of the numbers tells you a lot more about where the economy is headed.

Key indicators

You can also get a reasonable idea of the economy's direction by tracking certain leading indicators. These include:

• industrial production
• money supply
• the relationship between new orders and inventories
• housing starts
• disposable income
• retail sales.

Conduct a quarterly and annual rate of change analysis for each of these indicators and you'll have a pretty good idea of where the economy is headed. As with your own company, the direction and rate of change carry a lot more weight than the numbers themselves.

Preparing for the downturn

We recommend seven steps for preparing your company to ride out the economic storm.

1. Analyse the business. Put together a five-year financial history of the business and look for trends in key financial ratios. Compare your company's performance to that of the industry as a whole. Search for signs of trouble within your industry, such as:
   
   
   • excess capacity
   • unreasonably low prices
   • erosion of the top line.
     
     
2. Create a worst-case cash flow forecast. Build a worst-case scenario that assumes a 10% to 20% drop in sales. Identify the level of operating cash that is needed to run the business, and look at where you need to make cuts in order to ensure that the money going out doesn't exceed the money coming in.
3. Review the terms and conditions of your loan covenants. Go over the terms and conditions of your bank loan, making sure you have plenty of room to remain in compliance with all the covenants. Strive for a 10% buffer on every covenant.
4. Identify internal weaknesses. Look at every aspect of the business to identify internal areas of weakness, including:
   
   
   • over-staffing
   • excess inventory
   • too-liberal credit terms
   • increasingly ageing accounts receivable
   • declining quality standards.
     
     
5. Develop a contingency plan. This should include a combination of tactical and strategic planning that outlines specific measures your company will take should sales and profits take a nosedive.
6. Write an opportunity-based business plan. Put together a business plan that describes not just how you will survive, but how you will thrive during the economic downturn. Use the plan to convince your bank to lend you the money needed to acquire assets from financially troubled competitors.
7. Begin searching for acquisition opportunities within the industry. Pay special attention to competitors in financial trouble. However, wait until the economy hits bottom and prices become more realistic before implementing your acquisition strategy.

Acquiring troubled companies during a downturn

If you want to acquire a troubled company, you need to take four basic steps.

1. Make sure your company has a solid financial foundation.
2. Identify the prey (targets for acquisition).
3. Get a "hunting licence" (access to capital funds) from the bank.
4. Buy the assets of the target company.

Spot your prey

There are various ways of identifying potential acquisition candidates.

• Study the financial condition of your competitors via publicly available information.
• Compare competitor information with industry statistics.
• Find out who is accepting the unprofitable business you turn away.
• Talk to your counterparts in competing companies.
• Talk to your suppliers and customers.

Apply for your "hunting licence"

In order to grow when everyone else is cutting prices, you must have access to capital. This requires an opportunity-focused business plan that tells a compelling story. When approaching your bank for a "hunting licence" (a line of credit that allows you to pursue acquisition opportunities), bear the following in mind.

• You will probably have to pay a higher interest rate than you're used to.
• You will need to provide specifics about the deal.
• The bank will require a security interest in all the assets you intend to acquire.
• The bank will want your personal guarantee.

Once you have found a likely acquisition candidate, carry out an in-depth analysis of the company.

Buy safely

When acquiring a troubled company, make sure you buy the assets only, not the stock. Otherwise you will take on the firm's liabilities as well.

There are four routes through which you can acquire assets:

• bulk sale
• foreclosure transaction
• general assignment for the benefit of creditors
• bankruptcy.

Each method has distinct advantages and disadvantages. These must be assessed in relation to the specifics of the deal.

When buying assets from a troubled company, first compare the real value of the assets with the price you are paying for them. Then factor in the time it will take to complete the transaction, the level of risk from creditor claims, and the costs of defending yourself against those claims. If the numbers look good, proceed with the transaction. If not, wait until a better opportunity comes along.

Extending credit in a down economy

When the economy goes south, most companies tighten up on credit approval. However, smart companies look for ways to use the credit function not only to retain current customers but also to gain new ones. There are three important principles for managing the credit function during a down economy.

1. Hold on to your current customers. To stop your customers from bolting to the competition, add more value by lowering the cost of doing business with you.
2. Reach out to new customers. Look for ways to accept new customers you would normally turn away. This doesn't mean extending credit to anyone who walks through the door. However, if you can find a way to minimise the risk and remain confident of payment, there's no reason not to extend credit.
3. Use "product value at the time of sale" to make credit decisions. If you have unused capacity (the ability to accept additional business without increasing fixed costs) and there is high demand for your product, you can accept a higher level of bad debt and still make a profit.

Whether in good times or bad, the only reason to extend credit is to complete a sale you would otherwise lose. Never extend credit without a valid reason, especially during an economic downturn.

Stepping up the accounts receivable process

During a soft economy, collecting on accounts receivable (A/Rs) becomes more important than ever. To collect on delinquent accounts in a timely manner, you need to:

• understand why the customer hasn't paid
• close the "sale"
• track your A/Rs on a daily basis
• maximise your collection efforts.

1. Why hasn't your customer paid?

Past-due customers fall into three categories.

• Slow payers are good, stable customers who have the ability to pay. When they send you a cheque, you know it will clear.
• Problem payers have either systems problems or financial problems. Systems problems involve some glitch in the process that prevents the customer from paying. It may be a missing contract or purchase order, an unused or misapplied credit, or lost paperwork. Financial problems, which can be short term or long term, occur when the customer doesn't have the money.
• Avoidance payers deliberately try to avoid payment. Fortunately, they represent a very small percentage of delinquent accounts.

To find out which type of customer you are dealing with, contact the decision maker and start a conversation along the following lines:

Listen closely to what the decision maker says, and to their answers to your further questions. These will tell you whether the customer is a slow payer, a problem payer or an avoidance payer.

2. How to close the "sale"

Once you know the customer type, you can make an appropriate presentation aimed at collecting your money.

• Slow payers: Focus on getting them to pay you more closely in accordance with the agreed terms of sale.
• Systems problem payers: Identify any problems and fix them immediately.
• Short-term financial problem payers: Express a willingness to work with them, while selling them on the benefits of continuing to buy from you.
• Long-term financial problem payers: Cut them off at once or put them on COD only.
• Avoidance payers: Put them on COD and send their account to a debt collection agency or a lawyer.

If you have succeeded in closing the "sale" by getting a firm commitment from the customer on when they will pay, follow this up by using a good contact management system to track the account.

3. How to track your A/Rs

To make sure your people contact past-due customers in a timely manner, we recommend a daily A/R contact report that tracks four critical areas:

• the customers your A/R person has called that day
• the outcome of each conversation
• when you can expect payment from each delinquent customer
• whether or not customers have paid when they said they would.

4. Maximising your efforts

To enhance your collection success rate, follow these guidelines.

• Start early. Contact all delinquent accounts within three to five days of the date they become overdue.
• Go after the big money first. Call the customers with the largest outstanding accounts first, then work your way down to the smaller accounts.
• Keep a log to track systems problems. This makes it easier to collect your money while upgrading your business processes at the same time.
• Get the right person for the job. Recruit outgoing people who enjoy interacting with others and talking on the phone.

Getting out of trouble

Suppose reality exceeds your worst-case scenario and you find yourself in serious financial trouble? What can you do?

First, ask: "How did we get here, how serious is the situation, and how much time do we have?" Then implement the following plan.

Your 10-point recovery plan

1. Go into full crisis mode.
2. Protect and manage your cash flow.
3. Reinforce financial discipline.
4. Attack the gross margins.
5. Work with your bank and creditors.
6. Create a cost-control team.
7. Revise the organisational structure.
8. Protect your service and current accounts.
9. Focus on the core business.
10. Identify a new model for the business.

Developing financial discipline

Once the immediate crisis has passed and you have achieved a positive cash flow for the short term, you need to practise ongoing financial discipline to achieve long-term profitability. The following are among the steps you should take.

• Strive to increase your cash buffer.
• Tighten up on accounts receivable.
• Reduce inventory.
• Liquidate under-utilised assets.
• Extend payables.
• Track key balance sheet ratios.
• Continually reforecast sales.
• Keep a lid on cost of goods sold.
• Tighten credit.

Your role as leader

Ultimately, turnarounds require intense focus from the person at the top. In the simplest terms, you need to:

• control the cash
• clarify your market differentiators
• stay lean and mean
• raise expectation levels
• over-communicate with employees and customers.

More than ever, your people will be looking to you for guidance and direction. So take charge, act swiftly and decisively, and lead the way.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.