How Will The 2023 Economy Impact Small Business Owners?

As we enter 2023, the business and economic environment has nearly as much concern and uncertainty in this year ahead as it did a couple of years ago when the world was rocked by COVID.? The news headlines are full of debate about recession and inflation.? Interest rates have climbed incredibly fast.? The stock market has fallen sharply, with the NASDAQ down about 30% from its level a year ago.? Even among Wall Street's top financial institutions there is a wide range of expectations about where the economy will go in 2023.

How will this impact small businesses and business owners?

What businesses will come out ahead in the next year or two, and what decisions can businesses make to strengthen their odds of success??

What Is The Situation, and How Did This Happen?

Understanding what position the economy is in and how it got here will provide an important foundation to where it will be in the future, and how that future will impact each of us.? Here is a simplified version of the history leading up to the current economic situation, why there is a problem, and where the economic environment appears to be headed.

Over the past 40 years, the United States (and much of the developed world) has had the most consistent and sustained period of economic growth in history.? Interest rates have declined slowly and steadily since the 1980s and have been very close to zero in the past few years.? This has allowed entrepreneurs to borrow money freely and inexpensively, and to use the money to drive future growth and take entrepreneurial risks. ? Investors and banks have invested money into businesses using very low cost of capital.? Savings accounts have paid nearly zero interest, so the only way to make a significant investment return on excess cash was to take some risk.? This has driven our business world to thrive.

Then came COVID.? In the first few months of COVID, the world came crashing down on businesses in many industries.? Consumers stopped spending money and didn't leave home for a year.? Entire industries (hospitality and tourism sectors) completely collapsed.? Government pumped bail out money into the economy through PPP loans, EIDL loans, tax rebates and more, using broad brush stroke decisions that favored speed over verified need.? Many that lost their income were able to fortunately sustain themselves because of the government programs in place.? Those that kept their jobs and salaries were generally able to save a lot of money.? Many business owners who kept their companies going and retained most of their employees came out significantly ahead financially.

As COVID vaccines and treatments became prevalent and consumer behavior returned to some normalcy, the world was flush with cash.? A Bloomberg article from November 2022 describes it like this.

In the 50 years leading up to 2022, American households combined have held inflation-adjusted cash in their bank accounts of about $500 billion to $1 trillion.? In 2022, this number has jumped to $5 trillion!? So families in the United States, on average, have about 5x the cash balance compared to any point in history.?

Therefore in 2022, the world has money to spend with less concern about the price they pay for goods than ever.? Add the impact of supply shortages for consumer goods, vehicles, and commodities impacted by the Ukraine-Russia war and prices started rising quickly for a lot of things in 2022. ? That's inflation.? Without going into the details, inflation is considered to be very bad for economies, and it must be controlled and held at low levels (2% per year is in the ballpark of optimal).

As all of this was happening, the governing body responsible for controlling all of this in the United States, the Federal Reserve, was late to respond to the problem.? They thought the situation would be short lived and temporary.? Now they know they were wrong, so now they're scrambling to try to fix the situation.?

In short, the main problem is that the world is spending like it feels too wealthy, which is leading to consequences that need to be curtailed and controlled right away.?

How Does This Situation Get Fixed?

Fixing the situation means getting everyone to reduce their spending on a nationwide scale.? Additionally, most first world nations are having this problem so we're actually looking at a reduction in spending on a worldwide scale.

Fixing this situation is tricky, because it's a bit like shooting at a moving target with a time delay between when you pull the trigger and when the gun fires.? You take some shots at where you think the target will be when the bullet lands, but you don't really know whether they landed near the center until many months later.? It's easy to overshoot or undershoot.? The government has vocally committed to erring on the side of overshooting - which means if they have to miss, they're intending to miss on the side of over-slowing nationwide spending rather than failing to slow it enough.

The Federal Reserve in the United States really has only one major tool in the toolkit to control spending in the economy - raising or cutting interest rates.? The Federal Reserve has been frantically and hastily raising interest rates lately.

When interest rates increase, this reduces spending and slows the economy on multiple fronts.

First, businesses and consumers need to pay more money in interest on new loans and variable rate loans (for example, a business line of credit, a new vehicle loan, a new home loan), which leaves less money available to spend on other things.

Second, it encourages savings (rather than spending) because the amount of interest earned from holding money increases.

Third, it discourages lending and investment to businesses.? Businesses that have a lot of debt now are at higher risk of struggling financially as the impact of higher interest expense affects their bottom line net income. ? So net income goes down, banks get more critical of who they lend to, investors get more critical of what businesses they invest in, and businesses have less money to spend to fuel their growth.? Hence, spending reduces.

This cycle in the third point perpetuates itself.? As businesses have less available money, they are at bigger risk of not paying their bills so bad debt increases.? Their own revenue growth slows because their customers are paying more for their new home loans, or for B2B companies the financial health of their clients is deteriorating.? Companies that used to be barely profitable now are at risk of operating at a loss, or needing to reduce overhead as revenue slows and credit worthiness becomes a greater consideration to take on new clients than it had been in the past.

Fourth, investors who had previously borrowed money against their existing assets to invest in businesses are now less motivated to do so.? An investor can now make a higher guaranteed return by paying down their line of credit or holding cash in a high yield savings account.? Plus, the businesses they would have invested in are riskier than they used to be as mentioned in the third point.?

Add it all together, and the negative impact on businesses can be pretty substantial compared to what we've enjoyed in the decade leading up to COVID.

What Does That Mean For Businesses In 2023?

As discussed above, there is still a lot of money in bank accounts right now.? A lot of people still feel wealthy and are still spending.? So a lot of businesses are still reporting high levels of sales and aren't seeing deterioration in the credit worthiness of their customers yet.? Their only significant pain so far is higher interest expense.? If you own a well capitalized business with high equity, low debt and a reasonable profit margin, you're in pretty good shape right now.

This will start to get worse in 2023.? It will probably take a couple of years (or maybe more) for the country to spend its $5 trillion in savings down to normal levels.? The Federal Reserve is trying to slow the spending of those funds through higher interest rates.? But eventually much of that money will be spent, at which point we'll be left with a slower economy, businesses that aren't thriving like they used to, and a significant reduction in customers that spend freely.

The net income of businesses across nearly all industries will be lower than they are used to.? Those that are in more precarious situations won't survive, starting with the ones that require bank loans and investors to survive because they aren't profitable today.? Valuations of companies will decline significantly because net income will be lower and cost of capital will be higher.? (Valuation of a company is essentially a computation of the future cash flows of a company, which will be lower in the future, divided into an interest rate called cost of capital, which will now be higher).? A steady, established company that might have been worth $10 million a couple of years ago might be worth half of that or less by the end of 2023.

Banks will be significantly more critical in choosing who to give loans to, which will perpetuate the survival problem.

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What's A Small Business Owner To Do?

1.? Understand The Environment

First and foremost, understand what is happening in the economy.? Business managers who make decisions based on growth expectations the same way they were doing in 2019 or early 2022 are at high risk of putting down their bets without noticing the game has changed in front of their eyes.

Companies that thrive when customers borrow money are likely to be the most impacted early on.? Customers aren't going to be borrowing money like they used to.? Home remodeling businesses that generate revenue when homeowners take cash out refinance loans, for example, are going to see that revenue source dry up.? Real estate sales volume has already reduced significantly due to higher mortgage rates.

Customers that heavily rely on advertising to acquire new customers, such e-commerce businesses without high customer reorder rates, are likely going to face stronger headwinds in the future as consumers tighten the grasp on their wallets.? (E-commerce businesses have already been suffering from major headwinds since mid 2021 when Apple started curtailing Facebook's access to personal information of iPhone users).? Retail businesses will similarly see challenges. Companies that sell high ticket items that are usually financed by customers (vehicles, heavy equipment) will experience sales declines when the cost of financing increases for their customers through higher interest rates.

Anticipating changes in your business through a candid lens is the first step to dealing with them.

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2. Reduce your risk

Individuals and businesses should use available capital to pay down lines of credit with variable or high interest rates.? This is a great time to have credit available, but not to be saddled with high interest expense. ? This will reduce interest expense, which increases net income, and will reduce the debt the company owes on the balance sheet.? With available but unused credit, business operators can now be choosier about when to redraw from their line of credit to use that capital for situations that confidently provide a good return.? If something unexpected and unfavorable happens in the business (such as a major customer doesn't pay their bill), a business with less debt is in a better position to weather that storm, compared to if it is highly leveraged before that bad event.?

A successfully managed business in this economic environment will have higher cash, higher assets, lower liabilities, higher available (but unused) credit capacity, and higher equity than it had in the past.

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3. Understand Your Financials Better Than Ever Before

When the financial environment and outlook is more precarious, business management becomes more like walking on a balance beam than walking on a sidewalk.? Decisions will need to be made faster, and should be made based on trends, data and candid financial forecasts.? In other words, when times are good and the bank account is going up every month, the finer details of the financial performance aren't as mission critical as they will be in the environment most businesses will see in the next couple of years.? A bad financial decision - or a late decision from failure to know your trends and numbers - will be tougher to recover from.? The best business managers will increase their focus on real time analytics and timely, insightful financial reporting, so they can make faster decisions to control the financial health of their business.

In addition to financial reports, business managers should take action to increase their financial savviness. ? Now is the time to learn how to compute your breakeven point in dollars and units and to establish reporting that monitors how the breakeven point changes in the months ahead.? Metrics that were reserved for nerdy accountants and bankers like "debt to equity" or "current ratio" now will become common nomenclature in the monthly management discussions of wise CEOs.? If you don't have a CFO or an experienced controller to help you forecast your business into a changing and cloudier future, now would be the time to find the right one.

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4.? Focus on profitability and being cash flow positive

The businesses that are most successful in the upcoming environment will focus on profitability over revenue growth, keeping overhead lean so the company can be more nimble, and growth that doesn't suck cash.? Businesses that can do this consistently will be self-sustaining, will give confidence to banks and investors that they have a solid business model, will have improved access to new capital, and will be able to take advantage of competitors that are unprofitable or are overweight with debt.

For owners of pass through entities in particular, this may require a reduction in take-home income for the business owner in favor of leaving more cash in the company or paying down high interest loans.?

The first goal of all businesses should always be to survive for at least the next decade.? Those businesses that are not profitable or cash flow positive are at much greater risk of failing to reach this goal than they were in the past.? If changes might be needed to accomplish that, planning and discussion for what those changes might be should be started as soon as possible.

5.? Tighten Credit Terms & Policies

In the new economic environment every customer might not be a good customer.? Prudent business managers will increase their scrutiny about which customers are likely to pay their bills in the future compared to which ones are at risk of future cash trouble.? Requiring customer deposit payments up front, automatic payments, shorter credit terms and interest rates on late payments will help companies reduce their accounts receivable risk and may filter out customers that could have turned into a collections problem later.?

Business managers should be reviewing their accounts receivable aging reports more frequently in 2023 than they may have been in the past, and should be assertive in collections follow up before customers become significantly past their payment due dates.

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Conclusion & Final Thoughts

Although the expected depths of the economic downturn are debated among experts, nearly all agree that this is not a temporary change with a quick rebound.? It is a paradigm shift that may last for many years as an excess $4 trillion in savings compared to the historical average works its way out of bank accounts and the feeling of wealth associated with that excess cash subsides.

Prepare and be ready.? Don't be in denial thinking that the landscape has not changed.? Establish metrics and financial targets, and monitor business performance as actively as ever before.? Have a plan for what you will do if the financial situation shows leading indicators of deterioration.? If you're considering making major purchases, consider waiting a bit until you see how 2023 is shaping up economically with more clarity.

Most importantly, run a good business.? A good business is steady, lean, organized, predictable, profitable and cash flow positive, has a manageable level of debt, and does not rely on outside financing to survive.? If you are not experienced in transitioning your business from a growth-focused business to a "good" business, start looking for mentors and advisors that can guide you on the steps to adjust.

Wesley Lindquist has a CPA, MBA, has been the CFO at over 100 companies, and is the author of the book The Playbook To Managing Your Business By The Numbers available on Amazon.???Wesley is the founder of Precision Financial, a top quality service provider of managerial accounting services including bookkeeping, part-time CFO, financial statement production and forecasting.?Learn more at www.PrecisionF.com