Economic Storm Clouds are Here – Prepare Your Company for a Turbulent 2020
March 14, 2020 – With the U.S. stock market on a roller coaster ride with daily swings of thousands of points, the expanding economic effect of the COVID – 19 virus, and several of the world economies facing economic downturns if not full blown recessions (Germany, China, U.K. and others) economists are re-evaluating the chances of a U.S. recession in 2020. The latest signs of a potentially weakening economy were strong enough to help persuade the Federal Reserve to lower interest rates in early March to near zero rates and the federal government to declare a State of Emergency.
Despite record employment even through February, there are clear signs that the U.S. economy is weakening and that an economic downturn, perhaps not at the recession level, is approaching. The economic effects of the COVID -19 virus will effect consumer spending, manufacturing production as factories shutdown and increase the federal budget deficit as the federal government funds health initiatives designed to mitigate the virus effects. Trillions of dollars of wealth have already been lost due to the rapid decline in value in the stock market. Bankruptcies in industries heavily affected by COVID – 19 will happen. The energy industry has also been heavily affected by the lack of demand but also the OPEC price war between Russia and Saudi Arabia.
It was likely, even without the breakout of COVID – 19, that our economy was headed for a slowdown. With COVID – 19, the slowdown was accelerated both as to timing and as to the magnitude of the effect.
A recent survey conducted by Duke University https://www.fuqua.duke.edu/duke-fuqua-insights/cfo-survey-december-2018 concluded that a recession was looking “likely.” 82% of the executives surveyed are of the opinion that a recession will happen by the end of 2020.
Extreme pessimists are usually wrong–but so are extreme optimists. A downturn, caused by the natural ebb of the economy or by a shock such as a geopolitical crisis, such as COVID – 19 is always a possibility, bringing back conditions we remember all too well from the years after 2008: declining revenues and margins, excess capacity, anxious employees and restless investors. Even if a recession doesn’t come to pass, your company might have its own downturn this year, caused by a new competitor or new substitutes for your products and services.
Newport LLC recommends that all companies, particularly middle market companies with limited access to the capital markets, start planning for the possibility of a downturn this year.
Below are 4 steps to take to manage your way through a potentially very challenging year.
1. Manage profitability
Most companies have a relatively narrow margin for error. A 10% decline in revenue could wipe out the entire bottom line of your company. Having a contingency plan to produce marginal, short-term profit despite a drop in revenues can make all the difference.
Consider doing the following:
- Develop forecasts based on optimistic, realistic and worst-case revenue scenarios.
- Formulate contingency plans. Make sure your top managers are on-board with the plans, and are ready to act quickly if revenues decline.
- Agree with your management team on early warning signals, such as a shrinking backlog, a downturn in customer-market indices, or a worsening sales pipeline.
- Be willing to adjust discretionary spending at more frequent intervals; for example, quarterly, or even on a rolling basis.
- Be ready to keep bankers and investors appropriately informed in case of a downturn and to communicate the actions you’re ready to take to limit the damage.
- Reduce inventory levels in anticipation of lower sales
- Renegotiate lines of credit and other debt as interest rates continue to fall.
2. Identify and maintain your strengths– and your best customers and Employees
Identify the strengths that have enabled your success to date, and those that will be important in the future. Which capabilities and skills are most critical? What distinguishes your ability to serve customers effectively?
Identify your highest-margin customers, and understand what you are doing right for them. Develop a game plan, in the event of a downturn, to protect and build on the strengths that have allowed you to be indispensable to them. In the event of a dip in business, rather than cutting costs across the board, be ready to shift resources to retain these high-margin customers.
Identify your most critical, high performing managers and employees:
- Conduct “stay” interviews with them to make sure they understand what is going on and that their contributions are valued. Solicit their ideas.
- Identify your lowest performing employees and take appropriate action, even if they have long tenure.
Continue to be creative in how you and your employees can add value for your customers without increasing your costs. Example: a professional services firm adds regular briefings to client executives to monetize its intellectual capital. A minimal cost initiative to the service firm but an effective way to maintain contact with clients and potential clients.
3. Be ready to decide what you can stop doing
Companies that create enduring value typically excel at discontinuing what no longer adds value. Be ready to make changes in cost structure that will least damage your strengths and will hone your value proposition down to what customers really value.
Comb through your cost structure to create a contingency plan for what you would cut. Identify what’s inefficient; what’s nice to have but dispensable; what’s there because of history, inertia or wishful thinking; what may have worked in the past but doesn’t anymore; what isn’t creating value as it used to.
Realize the challenges you would face in cutting costs. Most organizations aren’t adept at taking costs out quickly as revenues decline, and margins suffer. Even your most hardheaded managers will try to protect their own people first. As your company has grown, your operations have probably become more complex. Be ready to take a knife to any complexity that isn’t compliance-required or value adding. Consider outsourcing non-strategic company functions such as human resources, accounting and even finance.
4. Manage liquidity as hard as profitability
A downturn might force you to deal not only with negative growth but also with liquidity constraints. Trying to maintain liquidity on a smaller revenue base can be crippling.
You would need a plan to turn over every balance sheet dollar faster to contribute to working capital. You’ll need plans to:
- Maximize cash flow by narrowing the timing between sales and outlays for costs you incur in advance, such as inventories.
- Collect from customers faster. Consider offering discounts for paying promptly or require deposits from customers.
- Take advantage of increased supplier willingness to share risk and to provide favorable terms.
- Monitor your receivables against your payables and reduce your Cash Conversion Cycle days (time it takes for money to come in from customers against the days when your supplier payments are due).
- Move your customers to ACH from checks, which can reduce your Cash Conversion Cycle generally by 7 days resulting in higher cash balances in your checking account.
Be ready to shrink to survive
The list of things a CEO needs to do to plan to survive a downturn is long and can seem daunting. You would need to avoid disassembling what has made you successful while accepting the necessity of shrinking it for the near-term. Managing through the crisis may require some skills that have been rusting in your managerial tool case.
In the event of a downturn, you’ll no longer be insulated by growth. Disciplined decision making will be essential. You’ll need to lead with the right proportions of cost-conscious frugality and bold innovation.
Michael Evans is a Managing Director in the Newport LLC, an advisory firm serving middle market companies.