Economics 201- Get Ready Now For the Next Down Cycle

Author:Hank Harris
Publish Date: Jun 21, 2022 04:25 PM EDT

Tree growing in dry ground

The US economy goes through up and down cycles and has done so throughout history.

Most of those cycles occur "organically" meaning they are a function of basic economic factors (supply, demand, pricing, etc.), as well as mass human psychological reactions to those factors. For example, out of the five recessions I have lived through thus far, the first four were caused, respectively, by: oil prices and inflation, a major tax reform act impacting real estate, a technology bubble, and a housing-related financial system meltdown. The fifth was different – caused by an event exogenous to normal economic fluctuations, i.e., the Covid 19 pandemic. Because Covid came from outside the economic system, its impacts were unique in many ways. Add to that government response flooding money into the system, probably assisting an extraordinary recovery, but perhaps also setting the stage for the present. At present we have assets that are overvalued – almost across the board. We also have high inflation and a Federal Reserve with limited capacity to do much about it.

Will all of this take us into two or more consecutive quarters of negative GDP growth (the technical definition of recession)? Something milder, or something worse? Of course, no one knows for certain; if they did, we could all make absolute response plans. There are many mixed signals in the market right now and some of them are indications of economic contraction. Now is the time to be thinking and planning for how your business will respond. After all, we do know with certainty a down cycle will come; the only real question is when.

Here are some things to consider as you plan forward:

  • Overhead – in upcycles, overhead tends to grow in just about every company. Look at it line by line to see where it can be surgically reduced. Most businesses can cut 10% out of overhead without hampering operations, or thinking too hard about it.
  • People – We are still dealing with an inadequate talent supply, so this is potentially a complex issue. Big public companies are already undertaking blanket reductions in force. This might be the wrong move in private companies, but there might be an opportunity to upgrade talent while also pruning underperformance. In management, most companies perform better with fewer highly competent people than numerous weak ones.
  • Small expenses – Small things taken for granted in good times often deserve scrutiny. When the 2008 recession hit, one of my client companies looked at the cost of employees "Fed exing" packages. They discovered a surprisingly large number and decided to forbid the use of courier services. Should gourmet coffee be free and unlimited? Employee travel and entertainment? Benefits and perquisites? This may sound like penny-pinching, but it all adds up and we are talking about a difficult business climate. And you don't want to be the only one thinking this way. You want everybody thinking this way, especially your managers.
  • Cash – Management of cash flow is always critical, but never more so than during a downturn. Running out of cash can happen, even to profitable companies; and if it does happen, it's game over. It is the one mistake management simply cannot make! Some suggestions:

1. Make it the topic of all management meetings

2. Measure your average age of accounts receivable – monthly

3. Measure your cash conversion periods and cash demand period – monthly

4. Maintain a 90-day rolling cash flow projection

5. Make sure the responsibility for collection of receivables is crystal clear in your organization

6. Be careful about paying bonuses from accrual-based profits; consider cash management in your incentive plans.

  • CAPEX – Spending requirements for equipment and other fixed assets vary by type and size of business. Often, there are rules of thumb on average amounts that are published for like-kind businesses; none of those are perfect, but they can be useful benchmarks. Venturing into a down economy, it's wise to be conservative and perhaps spend less than you might otherwise in your annual plan.
  • Debt – Similar to the above, there are no absolutes, but there are benchmarks that might be referenced. Obviously, a highly leveraged business going into a downturn poses an increased business risk. This is especially true if company performance is erratic, or the balance sheet is weak. On the other hand, some companies should consider long-term debt a hedge against future down cycles. This is true for two reasons. First, most companies acquire bank debt best when they don’t need it (if you need it, you're likely to not get it). Second, long-term debt puts "dry powder" on your balance sheet and most of the liability is long-term, so it's a boost to working capital. Even if the interest rate spread costs you, you can view it almost like a form of insurance.
  • Business Plans – Tough markets are usually when your annual business plan should probably be a form of "scenario planning." You may want to create three financial pro formas – a best case, worst case, and most likely. Also identify some milestones (e.g., the end of the first quarter) and identify what actions you will take if you're not seeing certain levels of revenue or gross profit.
  • Management Team – Take a look at your managers and assess how many of them have experience managing through a typical recessionary period (the pandemic doesn’t count, as it was very atypical). For some businesses, this will be a great vulnerability. Plug experience gaps where you can and get your team ready for a different sort of fight.

There is little downside to thinking now about how you will navigate a more difficult market and there is a possibility of great upside. An old homily suggests that there are 3 kinds of companies – the kind that makes things happen, the kind that watches things happen, and the kind that wonders what happened. Make sure your company is in the former category. That will mean instilling rigor, discipline, and excellence of execution in your organization. It will mean being proactive at all levels. But, that's what gets companies through tough markets.

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