Evaluating Your Recession Resilience

“The next century will be the century of complexity” – Stephen Hawking, January, 2000?

Almost a quarter of the way through this century, I think few would disagree with Hawking’s prediction.? Oftentimes, the best way to navigate through complexity and uncertainty is with a simple framework.? With the threat of a recession being top of mind for board directors and executives, leveraging your financial statements – balance sheet, income statement, and cashflow statement – can provide that simple framework to assess the health of your business in the face of a potential recession.

Quick note: this assessment technique may not work perfectly for every industry, like banking perhaps, or if your company is already in trouble, but it should be effective for most industries and scenarios.

Balance Sheet

Step 1. Evaluate your Current Ratio (Current Assets/Current Liabilities) and Quick Ratio (Liquid assets/current liabilities).? On the surface, this will give you an immediate assessment of financial health in the event of something major.? Theoretically, the higher the ratio, the healthier.

But here’s the counterargument – Current Assets are inclusive of Receivables (money the company has yet to receive) and Inventory (products the company has yet to sell).? What happens in the event of a recession?? More uncollectable receivables and inventory sitting on shelves (until prices are discounted heavily enough for customers to buy)!? I recommend optimizing these BEFORE a recession hits.? Not only will it protect you during a recession, but could free up significant working capital.

For receivables management, consider two technologies: intelligent collections and dynamic credit (both are SAP capabilities).? Intelligent collections will help your collections team prioritize accounts based on payment history and other factors.? Dynamic credit, which is particularly helpful if you are a global company and/or if you have customers with multiple products, services, and contracts, will give you a centralized view of a customer’s credit around the globe (including credit exposure and availability).? As business models evolve, dynamic credit management will support changes in credit based on new variables – e.g. subscriptions with cancellable/replaceable contracts.?

Inventory optimization typically starts at the source – demand planning and connected sales & operations planning.? Additionally, the ability to evaluate comprehensive network-based plans across all horizons (short, mid and long term) will help optimize inventory.?

The net of it: a cost-effective risk resilient supply chain (which can be delivered by a modern supply chain platform) has 3 key characteristics:

1. Consistent end to end processes to drive performance around the globe.

2. The ability to contextualize every decision by linking operational and business data together throughout the work process.

3. Collaboration in your ecosystem by creating digital connections with all of your partners for a more resilient supply chain.

The final point I will make about the balance sheet pertains to debt. ?A recession would likely lead to rate reduction, which removes that obstacle.? The bigger recessionary concern is deflation.? Deflation effectively increases your debt the same way inflation effectively decreases it.? If your organization earns high returns on investments funded by debt, this may be less of a concern.? But if not, it may make sense to pay off a lot of debt now, and then take advantage of deflation and the lower rates by taking out debt DURING the recession.

Income Statement

Compare your revenue growth over the last 5 years with your headcount growth.? Which is higher?? If, for example, your revenue grew at a 10% CAGR, but your headcount grew at a 15% CAGR, that is generally symptomatic of poor processes and old technology.? The financial impact of addressing this can be substantial (I wrote about it here: C-Level Executives: Your Broken Processes Are a Gold Mine for Your Enterprise).? In these situations, even with identified problems and solutions, some executives will elect to do nothing.? But remember that “do nothing” isn’t the absence of a decision, it’s a decision to keep bleeding profit, which will limit your pricing flexibility, reduce earnings, and unnerve shareholders.? Additionally, an optimal human capital strategy necessitates focusing on technology and process optimization to free up employees from low value add tasks and give them the tools to be great at their jobs.?

For a B2C enterprise, it is especially important to consider the impact of a recession on a population that a) may lose jobs and/or bonuses and b) is already quite leveraged.? Will you have to lower your prices to move products?? If so, can you make up for it with volume?? How would that be accomplished?? For some, it may require increased promotion spend.? Others may benefit from new distribution relationships (e.g. Monster Beverage’s relationship with Coca-Cola distribution enabled ?considerable global expansion).

Reviewing COGS: I already touched on what a modern, resilient supply chain looks like.? I once again encourage an evaluation of operations.? Do your margins give you pricing flexibility and a competitive advantage?? Are they trending in the wrong direction?? If so, modernization in this area now and during a recession can set you up for considerable success post-recession.?

It’s also worthwhile to look at vendor payments and determine what you value most – early payments to get the biggest discounts or later payments to maximize working capital.? Your choices may vary depending on vendor and impact.

Cash Flow Statement

I’ve already talked about reducing Receivables and Inventory in the Balance Sheet section.? This has the added benefit of improving cash flow.? Two more items worth evaluating are capital expenditure and employee compensation.?

Capital expenditure is generally necessary for growth, but consider analyzing the necessity of all projects.? Can certain projects be put on hold?? What does your return on invested capital tell you about the quality of your projects?? If it’s not impressive, consider a different approach to project selection to improve ROI and preserve capital.

Look for ways to counter capital expenditure by saving money elsewhere.? For example, if your employees have transitioned to remote or hybrid work, is there an opportunity to buy out of leases and/or rationalize your real estate portfolio?

Lastly, consider more equity-based compensation for employees.? Many investors cringe at the thought of equity-based compensation because it feels like it dilutes their investment.? I disagree.? As an investor, I love when I see employee incentives aligned to company success.? Plus, most companies have some form of share buyback strategy which should mitigate any dilution caused by equity-based compensation.? Plus, equity-based compensation improves cash flow – not just in theory, but mathematically!

I do not doubt that executive leaders have their own systems for evaluating whether their company can weather a recession.? Using financial statements as a simple assessment framework is one potential system – not just for risk mitigation, but to identify opportunities for value creation.

If you have any questions or would like to discuss the topic further, please feel free to email me.