Protecting your business from an uncertain economy

by John R. burgess

Recently, the Federal Reserve took the unprecedented step to make $200 billion available to the nation’s biggest banks and investment houses on very lenient borrowing terms in an extraordinary move to ease the credit crunch. The crunch was caused by the collapse of the subprime mortgage market and had resulted in tighter credit standards by the financial industry.

The Federal Reserve is adding billions to the money supply in a bold move to increase economic activity so that the nation can avert a recession. The multiplier effect on increasing the money supply is about 4.5 times every dollar added, so the practical effect of this $200 billion infusion is about $900 billion in additional economic activity—all from just one decision made by the Federal Reserve.

This bold action should be welcomed by all after the credit markets were rattled by the collapse of the subprime mortgage market and the subsequent decline in home values. Those same home values, during the past 15 years, helped to drive economic activity as homeowners used the leverage of their home equity to make home improvements, buy cars, take vacations and essentially extend purchasing power with transactions financed through the leverage of home equity. With housing prices falling in most areas of the country, the economy can no longer depend on homeowners to use home equity to drive economic activity. Whether or not this action by the Federal Reserve is enough to keep the economy from slipping into a deep recession, as some economists had predicted would happen without action by the Federal Reserve, no one knows until we ride out the next several months. However, business owners can’t afford to wait until the economy provides a clear indication of where it is heading. Waiting can be costly for an unprepared business owner—if the economy slips into a recession. Defensive measures that could have been taken earlier to protect profits—and in some cases, the viability of the business altogether—will have less of an impact.

The time to take action to protect yourself against the risks of recession is before the recession actually takes hold of the economy. Every business has costs to cut. When businesses are in a growth mode, inefficiencies and waste are hidden by growing revenues. As growth slows or revenue actually declines, these costs must be rooted out and eliminated. Owners need to review labor costs, overtime and overhead. Inventory should be reviewed to eliminate what is not producing a profit and the carrying costs associated with it. This will increase cash flow and reserves. Credit and collection policies should be reviewed with an eye toward increasing cash flow. Proactively collect receivables, and have policies in place to eliminate risky extensions of credit to those who may not be able to pay you back in the event of a recession. For some businesses, the difference between surviving and dying in a recession is whether they aggressively manage their cash flow.

Review all overhead costs. How does your cost structure compare today with what it was a few years ago? Compare the percentages you are spending on each category of your business as a percent of revenue. If your overhead was 22 percent of every dollar of revenue four years ago, is it the same today? Or, have you let it creep up to 24, 25 or 26 percent? Business owners should budget percentages, not dollars. Control the percentages you spend on each major cost category of the business.

If there has been an increase in costs as a percentage of revenue over the last four years, you will better understand the relationship between controlling your costs by a percentage of revenue and your profit margin. If you find that your costs as a percentage of revenue have increased in particular categories, those cost increases were either hidden from view by increases in productivity as revenues rose, or they resulted in a shrinking profit margin. Both cases can put you at risk if the economy heads into a prolonged recession.

It is imperative to remember that only the strong survive during periods of recession and inflation. In these times, it becomes even more incumbent upon small and medium-size business owners to manage every variable so that it exists to increase the odds of being as lean and mean as possible in order to insulate themselves from the perils of an economy faced with a recession or inflation.