When Good Times Hide Bad Problems
I’m just old enough to have experienced the last downturn.
When it hit, I had been an accountant for about six years. Those were boom years, and as a fledgling CPA I became accustomed to a world where sales went up every year and property ever steadily increased in value.
When the good times ended, I remember agonizing with clients. Should we cut the company health insurance contribution? Are we really going to have to let Joe go? What happens if the bank doesn’t renew our credit line? Why did we build the new showroom right before the tide went out? If only we could turn the clock back and put that money in the bank instead!
In the heat of it I determined to never forget the lessons I’d learned. I would be the voice of caution whenever talk turned to a new shop or office, or to hiring a new class of engineers. I would push owners to make sure every cash outlay was truly worth it.
In the past couple years, I’ve lost sight of that determination. Things have swung 180 degrees. Instead of agonizing over who to let go, we’re agonizing over how to meet orders with a limited workforce.
The tight labor market has in turn justified spending on an endless array of new labor-saving equipment and technology. Banks and equipment companies are gladly throwing in cash to make these purchases happen.
In short, the last downturn is so long past that the caution of painful memory is fading.
But good times can’t go on forever. I’m stirring to action again. Now is the time, while you have options, to consider if your company is positioned on thick ice or thin. When the heat comes, will your company stay firmly above the water or break through the ice?
Based on experiences in both good times and bad, here are 7 warning signs that good times might be hiding big flaws in your enterprise.
Warning Sign #1. Inefficiency is masked with price increases.
Right now it’s easy to raise prices. If you’re even half-competent and available, you can command a premium.
But here’s the thing. If your margins depend on high prices, you are in trouble in the next downturn. Margins right now should be phenomenal, with room to drastically reduce if necessary. The focus now should be on boosting efficiency, not on raising prices.
Warning Sign #2. You don’t know what your unit costs are.
Good times seem to reduce the appetite for accurate costing. If a small business is bringing in $1,000,000 in profit each year, does management really need to know the true hourly cost of operating each CAT dozer or the exact cost of each chair coming off the assembly line?
Spend the money now to find out the real unit costs of your operation. When times get lean, that information will allow you to quickly react to keep your company’s financial health intact.
Actually, it will help you even now to focus on the items or services that really drive the bottom line.
Warning Sign #3. There’s no “magnetic energy”.
Employees, vendors and customers are surprisingly adept at knowing whether a place is going forward or backward. It’s a combination of factors no one really can put their finger on, but they know it when they see it. This package includes competent managers, a sought-after product, and a friendly and respectful atmosphere.
A place with this intangible energy generates loyalty. In a downturn that loyalty is collateral, and it comes when people feel part of something solid and worthwhile.
Warning Sign #4. A large proportion of sales are from one or two clients.
I know, I know, big customers keep the schedule full. Often big customers make up a big share of a company’s profits.
But in a downturn, you need diversity. Some sliver of your target market may actually thrive in a downturn and you need to be connected with those companies before the downturn.
Warning Sign #5. You aren’t watching monthly fixed costs.
By fixed costs I’m referring to rent, insurance, salaries, software, interest, and anything else that doesn’t change much each month. You really should be fixated on this number, because it will drive your cash burn rate in a downturn.
This point is related to Warning Sign #1 about margins. Your financial model should be able to cover fixed costs even if total sales and margins fall.
Take a look at how much your different departments truly cost. For example, a well-run finance department might come in at 2% of revenue. If you’re at 6% now, that could be a warning sign that fixed costs are out of control.
Warning Sign #6. Your fixed costs aren’t flexible enough.
Closely related to the previous point, but still quite different, this warning sign emerges when your fixed costs are fixed for a long period of time.
The Horton Group in their white paper Boosting Profitability With Flexible Overhead, suggests that 15–25% of all fixed costs should be flexible. “Flexible” is defined as being able to be shut off within a week. I generally agree with their idea.
Now is the time to consider leasing instead of owning, working with contractors instead of employees, and in general paying a bit of a premium to keep your options open.
Keep a potential downturn in mind when signing agreements. For example, when negotiating an incentive arrangement with a customer or employee, consider some kind of opt-out clause in the event of a recession.
Warning Sign #7. You’re banked to the edge of your collateral.
I was amazed at how banks fled their clients in the last downturn. If you are risky credit now, you’re company is probably toast in a downturn.
Along with reducing leverage, consider non-bank financing options. In a downturn, a private lender will almost certainly be more flexible than a bank. Keep your eye out for private funds, even if they demand a slight interest premium.
In Conclusion — Lead With Carefulness, Not Fear
Fear should not drive decisions. The intent of this article was not to be pessimistic about the economy or scare people into action. Rather, I’m reminding you that what goes up inevitably comes down. Now is the time to take logical steps to be prepared.