How to Survive a Downturn
An up-to-date plan covering bad times is essential
It's hard to worry about rain when the sky seems blue. But worry you should, for the signs of a storm are clearly there. Health care costs, under control over the last three years, are headed up again, and are projected to increase by 10% or more in 1998. The Federal Reserve is hiking interest rates again, raising borrowing costs and dampening both consumer spending and business investment. And with labor markets stretched tighter than a rubber band, competition for valued employees is leading to higher wages and better benefits packages. With pressure still on to hold prices down, the result is clear: Profits are going to get squeezed.
Naturally, that doesn't mean a recession is right around the corner. Unemployment is low, the economy is expanding at a robust rate, and the Fed still seems more worried about excessive growth and inflation than a business slowdown. Small businesses' hiring plans and capital expenditures remain strong, says William C. Dunkelberg, chief economist for the 600,000-member National Federation of Independent Business. And a recent Coopers & Lybrand survey shows chief executives from three-quarters of the nation's fastest-growing companies are optimistic about the economy over the next 12 months. In sharp contrast, a mere 3% of those surveyed were pessimistic about the economy's prospects.
"PLAN, PLAN, PLAN." Still, whether you think the expansion has legs or a downturn looms, it pays to prepare for adversity. The secret for surviving and even prospering during a downturn is to focus relentlessly on the most basic notions of running a business -- cash flow, accounts receivable, costs, and debt. Says Laurence Charney, group leader for entrepreneurial services at Ernst & Young, "You've heard real estate people talk about location, location, location? When it comes to small business it's plan, plan, plan." Adds James F. Lafond, midatlantic cluster managing partner at Coopers & Lybrand: "The companies that don't pay attention to the basics get into trouble when times get tough."
Just as you would map out the exit routes from your home in case of a fire, it's essential to have a business plan which covers bad times. An up-to-date plan allows you to ask a lot of "what if" questions. What if you lose a major customer? What if the cost of goods soars? Moreover, frequent reviews of your business plan can highlight emerging dangers, such as ballooning inventories or delinquent customer payments. Comments Pierson M. Grieve, retired chairman and CEO of Ecolab Inc., a Minnesota-based institutional cleaning and sanitizing company he built into a global powerhouse: "When you see problems coming, do something about it before they overwhelm you. And don't panic -- people don't think well when they panic."
The most critical item to track for any owner is cash flow. In part, that means keeping a close eye on accounts receivables. Check out your customers. Are they healthy or financially fragile? Are they up-to-date on their payments? Are you making money off your contracts or straining to service too many customers? Eugene W. Courtney, CEO of HEI Inc., a Minnesota-based company specializing in making custom-designed, ultra-miniature micro-electronic devices, warns that "lots of people bleed to death with little bits and pieces of unprofitable business." At the same time, avoid having your business be too reliant on one customer. Bay Cast Inc., a foundry based in Bay City, Mich., serves seven different market segments, including the automobile and aircraft industries, and steel mills at home and abroad. "Make sure you are diversified enough so that if one section of your market is suffering from bad economic times other parts may offset the ones that are down," says Scott L. Holman, head of the company.
A regular checkup stems cost creep, too, the bane of many businesses today. "Quite frankly, when times are good you really aren't scrutinizing the phone bills and looking for other ways you can save pennies," says Scott Daugherty, executive director of the Small Business & Technology Development Center at the University of North Carolina at Chapel Hill. "We don't go on a diet until the suit doesn't fit."
SITTING DUCKS. Ambitious capital spending plans are an easy target for cutbacks. Some investments, like new telecom gear, may cut costs and increase business. But other expenditures, such as the next tweak on a piece of software or the latest model of office or factory machinery, can be delayed without hurting the business. Bay Cast funds its capital spending out of profits, says Holman. "It takes you longer to do what you want to do, but it makes you stronger. "
When a downturn arrives, it's also important not to be caught owing a lot of money, say many small business advisers and longtime entrepreneurs. Bolster equity capital, pay down debt, secure lines of credit, and convert any remaining borrowings into fixed-rate loans to make financial planning easier.
Financial leverage can be toxic. What's more, bankers tend to be exuberant lenders during expansions. A recent study of more than two million commercial and industrial loans granted by 580 banks between 1977 and 1993, undertaken by Patrick K. Asea, economist at the University of California, Los Angeles, and S. Brock Blomberg, economist at Wellesley College, suggests that banks extend way too many loans when times are good. That optimism gets overextended borrowers into trouble during recessions. Over the past three years alone, bank commercial and industrial loans outstanding have been growing at double-digit rates.
In addition, the quality of those loans in a recession may be worrisome, too. Banks have increasingly been relying on "credit scoring" -- computer-generated, numerical quantification of a borrower's risk -- as one of the main criteria for making their small business loans. In the Federal Reserve's recent Senior Loan Officer Opinion Survey, about two-fifths of respondents said they always use credit scores when making small business loans, and one-fourth said they sometimes use them. The trouble is, credit-scoring for businesses is relatively new, and suspicions are widespread that loan difficulties will emerge when economic activity slows. What's more, a lot of credit card issuers are worried about how much personal credit card debt is being used to fund small business, says Mark Zandi, chief economist at Regional Financial Associates Inc.
Reducing debt doesn't mean shying away from banks entirely. Indeed, a secure credit line can be a lifesaver if the business turns down. "It makes sense to lock up lines of credit when times are good and to build up good relations with lenders," says Frederic W. Thomas, president of SCORE, Service Corps of Retired Executives, a 12,400-member volunteer program that matches volunteers with small businesses that need advice. "The flip side of this is to keep them up-to-date on what you are doing. Bankers don't like nasty surprises."
GREENHORNS. Building up cash on hand is essential, even if it means taking less money out for personal expenses. A lack of capital was the single most important cause of business failures in the Minneapolis/St. Paul area in the mid-1980s, according to Karl A. Egge, an economist at Macalester College in St. Paul. Similarly, the mixing of household and business monies contributed to the failure of a good number of the Arizona micro-enterprises along the Mexican border when the peso collapsed in 1994. As sales slowed, many freshly-minted entrepreneurs dipped into the business cash flow to pay for the mortgage, the car, or other household expenditures. They didn't plow money back into the business, says Frank T. Ballesteros, deputy chief executive at the PPEP Microbusiness and Housing Development Corp., a nonprofit lender to tiny firms in rural Arizona. Egge suggests as a good target having enough cash to cover fixed costs for 2-3 months, though that will vary by the type of business.
A strong cash position not only lets you withstand the valleys in your business, but provides the wherewithal to expand during a recession -- when assets are cheap and competitors are falling. As the oil bust hit western Oklahoma in the early 1980s, cash flows abruptly dried up, banks called in their loans, and lots of businesses went belly-up. But Ratcliffe Inc., a bookstore, office supply, and sporting goods retailer based in Weatherford, emerged unscathed. Indeed, the family business expanded during the downturn, snapping up bargains as other companies went out of business. "Our sales now are greater than they were during the oil boom," says Richard Ratcliffe, head of the 70-year old company founded by his father who is currently working on reducing outstanding debts and building up a strong cash position.
Of course, another option is to structure your business so a recession will inflict less pain. Savvy businesses are always looking for ways to turn fixed costs -- that have to be paid no matter what -- into 'variable' costs that can be more easily trimmed in a sinking economy. For example, even in today's age of downsizing, it's unpleasant and difficult to fire a permanent employee. That's why an increasingly common technique is to supplement a core labor force with temporary workers. Bay Cast, blessed with full order books, relies on temporary hires for about a fifth of its 110-person workforce. Similarly, judicious use of outsourcing may provide a good cushion against slow times. Dean A. Sundquist, CEO of Mate Precision Tooling of Ramsey, Minn., notes that if sales drop by 10% to 15%, cutting back on overtime and bringing in-house some projects you had farmed out during the good times may be enough to pull a company out of a slump.
To many small business owners, spending precious time on keeping a business plan up-to-date may seem like a luxury. After all, they are building a business, pursuing a dream, and jostling competitors for market share. Big mistake: especially if they are running so fast as to miss what is happening around them. One way to stay in close touch with market conditions is to aggressively build up an intelligence network. Talk to valued employees. Schmooze with important customers. Create your own kitchen cabinet of independent advisers -- which should include your banker and your accountant, suggests Don Craighead, a retired small business owner. Use their input to project out 12 to 24 months, recommends Coopers & Lybrand's Lafond, and regularly revise your business plan to reflect changing circumstances.
Of course, a deep recession on the national or state level can severely test even the best, most carefully monitored financial management. If business dries up, "You are at the lifeboat level," says retired CEO Grieves. "You only do the things that keep you alive and jettison the rest." Still, well-managed businesses have higher survival rates, and even new enterprises can make it through a downturn. About half of all one-year-old firms made it from 1990 to 1994, according to the consulting firm Cognetics Inc, despite the recession which ran from July 1990 to March 1991.
Entrepreneurs know that any business has to expect the curve ball, the wicked twist of fate. No one knows when the next recession will come. But with the U.S. economy entering the seventh year of economic expansion, the risks are rising -- along with the potential cost of being unprepared. "There will be casualties in this -- the people who don't pay attention, who don't do the right things," says Scott Daugherty. "But if you handle it the right way, then there is a good chance you will come out stronger."
By Christopher Farrell in St. Paul
TABLE: Getting Ready for Tough Times