One of the goals of the CFO is to make sure the company always has adequate cash to operate.

To accomplish this task, the CFO typically seeks adequate working capital loans and lines of credit from bank lenders. In addition, the CFO also monitors operations to determine whether the company is profitable and generating enough cash to service bank interest and meet operating needs.

But what happens when CFOs encounter forces beyond their control?

If There is No Recession, Why is My Business Struggling?

Most Americans regard the debate about a recession as academic. The National Bureau of Economic Research (NBER) typically does not declare a recession until long after the fact. However, numerous economists called a recession after the Commerce Department’s announcement of second quarter 2022 U.S. economy contraction of 0.9 percent following a first quarter 2022 Gross Domestic Product (GDP) decline of 1.6 percent.

Nevertheless, most Americans are not waiting to be told by either economists or NBER whether or not the economy is in a recession. More than 60 percent of Americans believe a recession is already here according to the IBD/TIPP Economic Optimism Index in August 2022 by Investor’s Business Daily.

Americans are feeling the effects on their pocketbooks as inflation hits energy, food and consumer goods.

As a result, consumer spending habits are changing with a decrease in discretionary purchases lowering sales for many businesses.

Likewise, bankers seem to have gotten the word as lenders have tightened credit standards on second quarter 2022 business loans per the July 2022 Senior Loan Officer Opinion Survey on Bank Lending Practices.

Moreover, inflation is hitting CFOs very hard as well with costs for raw materials and transportation rising at breathtaking rates—sometimes double or triple the year earlier costs. Passing price increases on to other businesses and consumers is complicated and difficult.  Additionally, the lag time to accomplish price increases means many costs are never recouped. Significantly, when customers slow or stop buying altogether, price increases become almost impossible to implement in the near term, leaving the producer saddled with negative gross margins.

Ironically, the country’s low unemployment level has served only to confuse the discussion about recession because typical recessions have been accompanied by layoffs and high unemployment.

However, unemployment statistics have masked a major cause of the recession: the fall in the labor force participation rate from 63.4 percent pre-Covid in 2020 to 62.1 percent in July 2022 per the Labor Department, or about 3 million less workers. The lack of labor supply—notice “Help Wanted” signs everywhere you look—is driving up wages as employers compete for a shrinking pool of workers. Yet when wages reach such high levels that businesses and consumers cannot afford to pay, a recession may be deepened and prolonged.

While the foregoing challenges are external forces the CFO needs to be cognizant of, what should be monitored internally?

Warning Signs of Financial Distress

Cash is critical. Just as an otherwise healthy athlete could die from unchecked loss of blood, so must a business have cash to survive by meeting payroll and critical operating expenses.

Accounts receivable aging out is a problem. The longer receivables age, the harder they become to collect. Furthermore, older receivables often become ineligible under bank borrowing formulas, and could therefore accelerate a cash availability crunch.

Many companies have built up their inventory in response to supply chain problems. While executives are quick to point out that they can’t sell inventory they don’t have in stock, a closer look may reveal an imbalance with lots of inventory that customers aren’t buying, but stockouts on high-velocity, must-have inventory.

Triggering bank covenants is both an indicator and a cause of business problems. Loan covenants are intended to establish minimum but achievable borrower operating and financial goals as a condition of the bank loaning the corporation money. Should the company fall short, this not only indicates that the business has problems, but also casts into doubt the repayment of the loan. Moreover, tripped covenants can create additional business problems when loan default provisions that impact interest rates and cash advances kick in, potentially worsening the company’s cash flow and recovery.

Laying out an Acceptable Turnaround Plan

One of the CFO’s responses to a covenant default should be a turnaround business plan. In several instances turnaround plans with implementation periods taking longer than a year were eagerly accepted by lenders. Why? In a recession lenders become preoccupied with more severely troubled borrowers who either have no plan at all or whose negative operating results are worsening. Banks applaud borrowers who show the initiative to engage a financial advisor, prepare a plan, and execute the plan.

What kind of plan has the credibility to gain the lender’s support? Generally unpersuasive and unhelpful are conceptual outlines or budgets lacking action items, as well as unwritten, oral assurances and scary predictions. The plan needs to be in writing, not verbal. Further, a valid plan must be more than a budget or a set of numbers. Remember, the company’s previous budget fell short.

Therefore, the acceptable recovery plan would lay out the activities the company will undertake to reach its projections. These action items would be backed up with detailed, written assumptions by line item while citing historical and recent run rates (not unsubstantiated, wishful run rates). A weekly cash flow forecast also gives the lender granularity while supplying the company with a management tool. Importantly, the plan would include specific milestones, timetables and executives assigned to accomplish such milestones. This type of plan increases the likelihood of implementation by enhancing the ability of both the bank and the CFO to monitor progress through meaningful and comprehensible oversight.

Navigating Financial Distress

Whether the American economy is facing a recession or already in one, history indicates that recessions eventually end after numerous companies have gone out of business and left employees jobless. Proper planning can help your company survive the recession and be prepared for growth thereafter. Here are some considerations:

• Put together cash flow projections to control cash in a variety of recession scenarios. Executive management needs this information in a usable format and a timely manner to enable them to make critical operating and marketing decisions necessary to survive economic difficulties.
• Implement price increase programs that restore profitability while maintaining customers.
• Formulate an accounts receivable collection program that is both considerate of customers and effective at bringing in much-needed cash.
• Rationalize inventory to get product turning at the same or at a better rate than industry peers in order to avoid stockouts while increasing profitable sales.
• During the Great Recession of 2008, many companies formulated a loan restructuring plan, an action encouraged and embraced by lenders.
• Despite company management likely spread thin, it’s critical to continue implementing the company’s plan and to monitor progress.

 

Written by Baker Smith. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com