Who Will Survive and Who Will Fail? Part 2 of 3 How to Improve Profitability During a Recession
Ask any business owner how well they are doing. The answer invariably will refer to the amount of sales that they are doing. As a consultant who has worked with many small and medium sized businesses from many industries and from small to large. I don’t judge a business from its sales but rather its profitability on those sales. Chasing sales is one of the main causes of liquidity issues in small and medium sized businesses. It ties up cash, increases accounts receivable and accounts payable and frequently leads to increased borrowing. This catches up to the business during slow downs and recessions. This blog provides some recommendations that will help to both improve your profitability as well as improve your chances of surviving a recession.
The following is based on my experiences with our own clients as well as the more than 100 accounts I looked after in my portfolio when I was on a collection team during a major recession in Canada.
Key Area: Cash
It may sound crazy but one of the major problems seen in many independently owned businesses is that as soon as they start making money they lose patience and want to take it out. The problem is that if your business is growing it needs more money to grow as it ties up cash in increased receivables and inventory. What the business needs is more equity. Many businesses, rather than investing more cash, borrow to cover this shortfall thus creating future problems particularly in downturns and recessions. The key is to leave the cash in your business to fund the future growth. Remember the real value in your business is only realised when you exit the business. You need to delay your gratification. Personally, I like to see small and medium sized business have sufficient non debt equity to cover, as a minimum three months sales. This gives you a buffer and time to change your strategies in the case of a recession.
Recommendation #1 - Try to have at least three months free equity to cover your sales
Key Area: Debt
One of the major causes of liquidity problems was an over reliance on debt. Many of them had borrowed money to offset working capital shortages. This is a recipe for disaster and in fact the strategy should have been to reduce sales. By reducing sales, you reduce the amount of receivables and inventory you have to carry thus reducing the need for additional debt or an infusion of equity. The solution to working capital shortages is the introduction of equity rather than debt. Ironically, reducing sales can lead to increased profitability due to improved cash flow and reduced costs.
So review the loans that you are carrying. The less debt you are carrying, the better. You often hear the saying that you should always use other people’s money to grow your business. This works in good times, not so well in the bad times. Not only does it mean that loan and other repayments will be a drag on your cash flow, but you also put the fate of your business in other people’s hands as they may decide to liquidate their loans at your expense. This also raises another good point. Many people get hung up on interest rates and my experience is that it is rarely the interest rates that kill you, unless they are truly excessive, it is the principal repayments.
One last thought on debt. While financial institutions still want to make loans during tough times, after all that is a key component of their business, they become much more conservative. This also extends to their patience or lack thereof with loans that encounter repayment problems. While they may negotiate a postponement of principal payments, they will not postpone the collection of interest. If you are unable to repay interest your loan becomes nonperforming and frequently leads to your loans being called. Also remember that the loyalty of financial institutions is ultimately to their shareholders and not their clients. They are a business just like you and not in the business of charity.
Recommendation #2 – You should try to run your business on a total debt to assets basis of less than 2-1 which provides you with some debt without stretching the businesses liquidity.
Key Area: Accounts Receivable
Another activity which added to the liquidity problem was the lack of attention to the collection of accounts receivable. It is important to stay on top of this aspect of your business but critical in times of recession or slow down. Remember your clients are going to be feeling the effects of the recession just like you and may be encountering cash flow problems as well. As a result, spotting problems early becomes very important so that you don’t keep selling to businesses that are in trouble. You also need to move early on accounts that you think may become delinquent and initiate repayment even if it means offering the repayment terms. Also, a quick reminder, most businesses stay on top of large accounts receivable but don’t forget the small ones as they quickly add up to a large amount. I always remember a client who was very good at paying attention to the large accounts receivable but not so much to the small ones of $50, $100, $500 etc.. They couldn’t figure out why they continued to have cash flow problems. When we totalled these small amounts, they totalled in excess of $150,000, a significant amount. So, remember to pay as much attention to these as the larger amounts.
Preference should be given to cash or credit cards payments. It is actually interesting how many US firms pay by credit card today and this is good for the seller as they receive almost instantaneous cash. If you do give credit, stay on top of it. In normal times you are good to let this run 45 to 60 days. In times of recession letting receivables run 60 days could be problematic. So why do we give credit anyway? It is usually to increase sales. In times of slowdown or recession this becomes almost an oxymoron, as in times like these we should be focusing on cash flow and profitability not sales volume.
Also make sure that you are not using your line of credit to purchase assets for your business as the line of credit is meant to offset the money tied up in your accounts receivable. Using it to buy assets reduces the amount of liquidity that you need to run your business.
Lastly you should be running credit checks on your larger customers at the best of times and this becomes even more important in tight times. Once you have run these credit checks establish credit limits and don’t exceed them for any reason.
Recommendation #3 – Try to keep your collection period for accounts receivable to 45 days or less. Once they get over 60 days the chances of collection are considerably diminished.
Key Area: Inventory
Overinvestment in inventory can cause trouble. Inventory of any sort by its very nature ties up cash at a time when businesses are trying to be as liquid as possible. As a result, you should only be stocking for your immediate and short-term needs. Managing inventory takes discipline and it is easy to rationalise why you should carry extra inventory such as it may be hard to get later, it will sell eventually and many other excuses. The temptation to overstock can be increased during recession when you will be offered the inventory of your competitors who have failed at very advantageous prices. You need to resist this temptation no matter how you rationalise it unless you have immediate sales and buying it does not impair your cash flow otherwise your business could join the ranks of the failed. If you haven’t set up an inventory control system already that monitors the levels of inventory that you carry as well as the quantities you should be ordering and when, you should do that as soon as possible and don’t wait until it becomes critical.
Another reason to stay on top of your inventory is that buying habits often change during recessions and you want to be able to change your offerings as these buying habits change which is harder to do if you are overstocked with inventory that is not selling.
A key fact to remember is that most inventory held for more than six months is already costing your business money and you should be looking for ways to move on “these old friends” and to get as much cash out of them as possible. The losses arise from opportunity costs, the money could have been used for goods that would sell thus generating a profit, the cost of the space they occupy, the cost of the money you borrowed because you were holding the inventory etc. At this point whatever you can get for it is a bonus.
Recommendation #4 – Review your inventory with a view to minimising the level held, removing old friends, and making sure that you only keep what you can sell. Ideally depending on your business your inventory should be turning over a minimum of 3 to 4 times per year.
Key Area: Accounts payable
Many businesses use their accounts payable as part of their financial strategy for financing accounts receivable. This works very well during normal times but can become high risk during recessions when your suppliers are also encountering liquidity issues. During these times their patience becomes strained and they are quicker to seek legal remedies to enable them to stay afloat. This in turn causes you grief. Try to keep them just over the time it takes you to collect your receivables.
Recommendation #5 – Always try to pay your suppliers after you have collected your receivables. For instance, if you collect in 30 days, pay your suppliers in 35 to 40 days.
Key Area: Assets
You also need to remember an old business maxim which we often forget. You should invest in those things that make you money. In retail and wholesale businesses this may be inventory, in a service business it may be people. An example of tying up capital is buying the building you operate from. It is tempting to compare the lease payments with the amount of the payments you would make on a loan and while this may look favourable at first sight it does not take into account the down payment which results in the tying up of capital. In fact, one of the first things we look at when looking for liquidity is to look at how much money is tied up in the assets owned by the business. We them employ various financial strategies to free up this capital. There must be a reason a Canadian Bank sold all its buildings and used the resulting funds to improve its equity. If it’s a good tactic for a bank to use it is probably a good tactic for most small businesses.
Recommendation #6 – Make sure your scarce capital is being invested where it will do the most good. Also, look for ways to free up the capital tied up in assets that you own.
Key Area: Costs
The initial reaction of most people during a recession is to look for ways to reduce costs. As you can see from the foregoing there are other areas that are probably more important. As a general rule only expenses that represent more than 5% of sales represent areas that will make significant contributions to the reduction of expenses. These areas typically include purchases (already discussed under the need to reduce inventory), rent, (usually covered by a contract although in tough times you may be able to renegotiate this), and wages.
They say that if you want to increase the value of a business reduce the expenditure on staff. The savings from this flow straight to the bottom line. But ask yourself, ‘Do they?’ The tendency is to let the experienced staff go first as they cost the most. The problem is that the inexperienced staff are less skilled and therefore less valuable and may be costing you business customers or even worse making it less profitable. Remember our contrarian mantra. Keeping your most experienced staff makes more sense as it is these people who have the relationships with your customers at a time while we are trying to keep the ones we have. They are your frontline to the changing needs of your customers and hence the changes you need to make to your business to survive. If you really need to cut costs in these areas, then consider job sharing first before you let people go. During times such as these when jobs are harder to find your staff will appreciate this and be even more loyal.
So, during tough times challenge every expense you want to reduce to ascertain the impact it will have on your overall business. The contrarian contention would be that sometimes during recessions you should increase some expenses rather than reduce them. A good example of this would be advertising and marketing expenses. Another favourite target of people looking to reduce expenses. During a recession competition increases due to many businesses chasing a shrinking pool of remaining customers. The prize of getting their business will go to the business that does the best job of reaching out to them which often means spending more.
Recommendation #7 – Think before you cut. Reduce costs intelligently.
Staying positive and focused is the best defence in a recession. People are still spending; you just have to get your share.