Best Practices: Managing in a Down Economy

Economic Outlook

After a prolonged period of growth, the U.S. economy has finally taken a turn for the worse. At the time of this writing (second quarter 2001), the economy -- or at least parts of it -- appears to have entered the first stages of recession.

TEC speaker Brian Beaulieu, an economist with the Institute for Trend Research, projects a fairly mild recession with a very strong recovery. TEC speaker Ed Freiermuth, a former banker and current turnaround strategist, foresees a slightly more painful economic adjustment and a milder recovery. Despite their divergent outlooks, both agree that the coming downturn represents a time of opportunity for well-managed companies.

Freiermuth attributes the current downswing to an excess of corporate and consumer debt and over-leveraged companies that have caused a credit crunch within the banking industry. Beaulieu believes the recession will unfold as more of a "sectoral" correction, with mature manufacturing and high-tech industries taking the brunt of the blow.

To prepare your company for recessionary conditions, Beaulieu recommends the following:

• Set conservative budgets so you don't hemorrhage 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 percent margin for error with your financial covenants.
  
  
• Prepare a comprehensive cash flow forecast that includes best- and worst-case scenarios.
  
  
• Scrutinize every job in the company to determine which ones are essential to the core business and which can be cut if needed.
  
  
• Once you have these defensive strategies in place, start thinking about how to position your business to take advantage of the next economic upturn. Despite his gloomier outlook on the recession, Freiermuth concurs with the opportunity for well-managed firms.

"Without question, the economy has taken a turn for the worse, and it will last a while,"he admits. "But that's bad news only for the companies that are ill-prepared to handle it.

For companies with strong balance sheets and cash flows, it represents a fabulous opportunity to acquire assets at discount prices."

Understanding Economic Cycles

According to Beaulieu, every economic cycle consists of four distinct phases:

• Phase A (Advancing). In phase A, the economy has hit bottom and is just beginning to come out of a recession. Trend data for sales, orders, inventory, etc., continues to look dismal (and may still be trending downward) but leading indicators point to a recovery in the near future. During this phase, companies should shed their defensive tactics and begin ramping up for the recovery.
  
  
• Phase B (Best). During this phase, the economy runs progressively higher than the previous year and trend data climbs at a sharp rate. Companies should take risks, budget for prosperity, implement aggressive expansion programs that were planned and staffed for during phase A, and roll out new products and services.
  
  
• Phase C (Cautionary). In phase C, the economy begins to weaken but hasn't turned overtly negative. At most companies, performance continues to run above previous year levels, but growth gets harder to achieve. Instead of pursuing growth, companies should stop hiring, avoid long-term purchase commitments, tighten requirements for capital equipment expenditures, weed out inferior products and begin implementing cost-cutting measures.
  
  
• Phase D (Danger). In this phase, the economy has turned overtly negative. Data trends have fallen below previous year levels and are actively declining for most businesses. Companies should manage for survival rather than growth, pay extra attention to cash flow, margins and key financial ratios, tighten up on accounts receivables, and adopt a defensive position vis-à-vis market and pricing pressures.

Taking advantage of economic downturns, says Beaulieu, requires the ability to predict with reasonable accuracy when one phase will shift gears into the next. This can be accomplished by:

• Conducting a 3/12 and 12/12 "rate of change analysis" for your company
  
  
• Comparing your company's rate of change to the economy as a whole
  
  
• Monitoring key macroeconomic indicators

To conduct the rate of change analysis, use a spreadsheet to aggregate your sales data into separate three- and 12-month rolling totals. To determine your "3/12" rate of change, divide the most recent three months' sales total by the same three months from the previous year. The "12/12" ratio works in the same manner except it involves a rolling total for 12 months rather than three. Ratios above 100 generally indicate favorable economic conditions. However, the direction of the numbers tells you a lot more about where the economy is headed.

You can also get a reasonable idea of the economy's direction by tracking certain leading indicators. These include industrial production, the U.S. leading indicator, the M2 money supply, the relationship between new orders and inventories, housing starts, after-tax, disposable income and retail sales.

"Conduct a 3/12 and 12/12 rate of change analysis for each of these indicators and you'll have a pretty good idea of where the economy is headed," says Beaulieu. "As with your own company, the direction and rate of change carries a lot more weight than the numbers themselves."

Beaulieu believes the recession (early phase D) will officially begin in the third or fourth quarter of 2001 and will likely continue through the middle of 2002. Phase late A/early B will occur in the middle quarters of 2003 and should signal the launch of another lengthy and very prosperous economic boom. Beaulieu's advice? Start laying plans now for how to take advantage of this upcoming macroeconomic expansion.

Preparing for the Downturn

Freiermuth recommends seven steps for preparing your company to ride out the economic storm:

1. Analyze the business. Put together a five-year financial history of the business and look for trends in key financial ratios. Use the "Robert Morris Associates Annual Statement Studies" to compare your company's performance to the industry as a whole. Search for signs of trouble within your industry, such as excess capacity, unreasonably low prices and erosion of the top line.
   
   
2. Create a worst-case cash flow forecast. Build a worst-case scenario that assumes a 10 to 20 percent drop in sales. Identify the level of operating cash 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 percent 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 aging accounts receivables and declining quality standards.
   
   
5. Develop a contingency plan. This should include a combination of tactical and strategic planning that outlines specific action steps 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 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 an Economic Downturn

According to Freiermuth, the process of acquiring troubled companies requires four basic steps:

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

To identify potential acquisition candidates:

• Study the financial condition of your competitors. Use EUCC-1 lien searches, SEC reports and other publicly available information.
  
  
• Compare competitor information to 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.

In order to grow when everyone else is cutting price, 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 license" (a line of credit that allows you to pursue acquisition opportunities):

• Expect to pay a higher interest rate than you're used to.
  
  
• Be prepared 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 find a likely acquisition candidate, proceed with an in-depth analysis of the company. For a handy guide to collecting this information, see "Acquisition Opportunity Due Diligence" in this Best Practices module.

When making acquisitions, buy the assets only, not the stock. Otherwise, you get the firm's liabilities as well. According to Freiermuth, assets can be acquired in four different ways -- bulk sale, foreclosure transaction, general assignment for the benefit of creditors or Chapter 11. Each method has distinct advantages and disadvantages which must be assessed in relation to the specifics of the deal.

"When buying assets from a troubled company, first look at the real value of the assets compared to how much you're paying for them," advises Freiermuth. "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 to gain new ones as well. According to TEC speaker Abe "WalkingBear" Sanchez, managing the credit function during a down economy requires three steps:

1. Hold onto your current customers. To keep 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 minimize 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 a 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," says Sanchez. "Never extend credit without a valid reason for doing so, especially during an economic downturn.".

Stepping Up Accounts Receivable

During a soft economy, collecting on accounts receivables becomes more important than ever. Sanchez recommends a three-step process for collecting on delinquent accounts in a timely manner.

1. Understand why customers haven't paid. Past-due customers come in three categories:
   
   
• Slow payers are good, stable customers who have the ability to pay. When they cut you a check, you know it will clear.
  
  
• Problem payers have either systems or financial problems. Systems problems involve some glitch in the process (i.e., missing contracts or purchase orders, unused or misapplied credits, lost paperwork) that prevent the customer from paying. Financial problems, which can be short- 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.
  
  
2. Close the "sale." Once you know what type of customer you're dealing with, you can take the appropriate steps to collect your money:
   
   
• Contact the decision maker. Start the conversation by saying, "Hello. I'm Joe Smith from ABC Company. Our records show that invoice #111 dated January 1 is still open. Can you help me with this matter?" Then sit back and listen.
  
  
• Determine the type of customer. Ask questions and listen closely. Their answers will tell you what type of customer you're dealing with.
  
  
• Make your presentation based on the type. For slow payers, focus on getting the customer to pay you closer to the agreed upon terms of sale. For systems problem payers, identify any problems and fix them immediately. For financial temporary customers, express a willingness to work with them while selling them on the benefits of continuing to buy from you. Cut financial serious customers off at once or put them on C.O.D. only. Put avoidance payers on C.O.D. and send their account to a collections agency or attorney.
  
  
• Close the "sale" and follow up. Get a firm commitment from the customer on when they will pay and then use a good contact management system to track the account.
  
  
3. Track your A/Rs on a daily basis. To make sure your people contact past-due customers in a timely manner, Sanchez recommends a daily A/R contact report that tracks four critical areas:
   
   
• Who your A/R person calls each 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

To facilitate your collection efforts:

• Start early. Contact all delinquent accounts within three to five days of becoming overdue.
  
  
• Call the largest accounts first. Go after the big dollars first, then work your way down to the smaller accounts.
  
  
• Keep a systems 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. Hire outgoing people who enjoy interacting with others and talking on the phone.

Turnaround Time

Suppose reality exceeds your worst-case scenario and you find yourself in serious financial trouble -- what happens then? First, says TEC speaker John Zaepfel, ask, "How did we get here, how serious is the situation and how much time do we have?" Then implement the following 10-point plan for recovery:

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

Once the immediate crisis has passed and the company has achieved a positive cash flow for the short-term, the next step involves practicing ongoing financial discipline to achieve long-term profitability. According to Zaepfel, this includes the following:

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

Ultimately, turnaround situations require intense focus from the person at the top. To keep things as simple as possible:

• Control the cash.
  
  
• Get very clear on 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," concludes Zaepfel. "So take charge, act swiftly and decisively, and lead the way!"

Contributing Experts:

Brian Beaulieu

Brian Beaulieu is an economist with the Institute for Trend Research (ITR), a New Hampshire-based nonprofit organization that uses scientific methodology to analyze market and economic trends and accurately project when those trends will change. Beaulieu currently focuses his efforts on applied research regarding business cycle trend analysis, growth cycle trend analysis, and the utilization of cyclical analysis at a practical business level. He is also engaged in fundamental research focused on long-range quantitative forecasting of basic industrial and financial trends. A regular contributor to several major financial publications and a frequent public speaker, Beaulieu currently addresses TEC groups on the subject of "Projecting When Economic Cycles Will Change."

Ed Freiermuth

Ed Freiermuth has more than 25 years' experience in financing and advising businesses of all sizes. He has worked directly with the CEOs and senior managers of more than 200 companies, and has served on or been an advisor to the boards of more than 15 publicly and privately owned firms. As an independent financial consultant and business strategist, he works closely with lending officers, attorneys, accountants, venture capitalists, investment bankers and others seeking to resolve complex financial, marketing and operational challenges. He has published two books on business management, "Life After Debt" and "Turnaround: Avoid Bankruptcy," and is a frequent contributor to leading business publications. A TEC speaker for over a decade, he has made more than 100 presentations to TEC groups on a variety of subjects.

Abe "WalkingBear" Sanchez

Abe Sanchez is the first visionary leader of the profit-centered credit and collection movement. Recognized as the leading practitioner in the field, he is the developer of the copyrighted "Profit System of Credit and Collection Management," a unique and well-proven set of methodologies that turns a traditionally viewed "cost center" into a proactive profit center. The author of numerous business articles, Sanchez's work has appeared in Wholesaler, Broadcast Cable, Bottom Line Business, Link, Colorado Business, The Rocky Mountain News, News From Indian Country and many other publications. A TEC speaker since 1994, Sanchez has worked with more than 100 TEC groups on "Customer Financing: The Focus on Profit, Not Risk."

John Zaepfel

John Zaepfel is CEO of the Zaepfel Group, a Newport Beach-based consulting and investment firm that helps companies design and implement strategy, improve their competitive advantage and increase their bottom lines. He has 15 years' experience as a hands-on CEO, having served as chief executive for two private companies and director for two publicly traded firms. In addition to his current consulting practice, he chairs two TEC groups in Southern California and sits on the boards of 14 different companies. A TEC speaker for more than a decade, he currently addresses TEC groups on "Managing by the Numbers," "Strategic Design and Implementation" and "Building Transferable Value." These experts were selected from TEC's stellar corps of speakers. TEC Speakers regularly share their expertise with individual TEC groups in highly-interactive half-day sessions.

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