Mixed signals dominate economic headlines as concerns persist about a recession beginning in 2023, if it has not already begun. The M&A markets became significantly more challenged in the second half of 2022, and deal activity reported by investment bankers and private equity financial buyers has slowed down, with uncertainty and rising financing costs playing prominent roles.
Not a day goes by without hearing some new statistic that confirms or denies one’s own opinion. We have heard that inventories, long a harbinger of future downturns, have increased from supply chain overordering to become a drag on pricing power. At the same time, employment remains strong, with the unemployment rate hitting an all-time low.
Business owners should diligently monitor the signals outlined below for early warnings about their own liquidity needs as the possibilities of an economic downturn persist. During any recession, cash is king and provides staying power for a business to ride out the storm.
Signals to Watch
Given Fed Chairman Powell’s latest remarks on potentially higher and faster rate hikes, it is critical for owners to take a hard look at their debt structures. In addition to modeling in elevated future rates to forecast budgets, reviewing amortization schedules is paramount. For example, businesses who took advantage of the “cheap money” from the Main Street Lending Program in 2020 are now past the two-year principal payment holiday and must ensure they can service the 15-percent annual amortization along with the higher-cost interest payments.
In addition to watching for inventory buildup, businesses should pay close attention to their accounts receivable collection time. An increase in days sales outstanding (DSO) may be a sign that customers are experiencing challenges, an early indicator of liquidity issues down the line. Analyzing current DSO relative to similar periods both during and pre-pandemic can give valuable insights. Both customers and vendors may face similar issues your company is observing, including the rising cost of debt, wage inflation, supply chain imbalances and more.
Watching for employee turnover is another key piece of the puzzle. Trouble retaining talent could be a signal that yet more wage pressures are to come, and this must be addressed in the company’s cash flow projections. As an owner, having an ear to the ground and watching for certain patterns — including widespread relocation to lower cost markets, well-capitalized competitors aggressively recruiting, the “quiet quitting” phenomena and employees retooling their skills for different industries — may provide clues on what’s to come.
On a macro level, weakness in publicly traded companies’ share pricing and multiples in one’s sector give insight into how investors are viewing the future, given the forward-looking nature of the stock market. This is important because it may ripple down into how a company’s bank or investor base may view the risk profile when more capital is sought. Recent news about both Silicon Valley Bank and First Republic Bank difficulties could be leading signs of additional bank trouble to come.
Steps to Take
To properly navigate potentially challenging waters this year, business owners should focus on increasing transparency, building liquidity, optimizing customer and supplier relationships and retaining talent. It is critical to take an unemotional look at this year’s budget, as well as future years’ budgets and forecasts, and consider alternative scenarios for sales, gross margins (preferably by SKU, channel and customer) and overhead costs to test where liquidity risks might present themselves.
Transparency with one’s capital providers is important ahead of a recession as banks and investors are often forced, in a tough environment, to separate their portfolios into “naughty” and “nice” lists. Being upfront about potential challenges coming down the pike before they trip financial covenants may allow a lender to be proactive in modifying a loan, for example, to enable a smooth relationship with a borrower and avoid things moving to the draconian, special assets side of the bank. Capital sources, like all of us, do not like surprises.
In terms of liquidity, an adage to live by is to raise capital when you can, not when you have to. Looking ahead and anticipating potential covenant issues can enable a business to access a variety of capital solutions, including subordinated debt and structured equity, that can help shore up liquidity without the equity dilution that may come if a company waits too long. While costs of capital may increase, the alternative potential existential threat and psychological comfort of having “staying power” are critical factors during uncertain times. A company’s bank may be able to introduce such capital partners and an investment banking advisor can run a robust process to make sure that no stone is unturned and that a menu of options is available for the owner.
When there are signs of stress in one’s supplier or customer base, leveraging longstanding relationships to have honest conversations is key. On the sourcing side, getting longer payment terms with vendors can be an incremental source of liquidity. With customers who are slow to pay, owners may sometimes need to make the difficult decision of tightening terms or moving on, shifting focus to a healthier set of customers.
To best retain one’s employee base, business owners should establish and maintain a culture where people feel like a part of something. Chasing wage inflation is a dangerous but sometimes necessary game, but the long game is more about empowering the team and providing long-term incentives. Similarly with capital providers, being transparent is the best way to maintain relationships through all parts of a cycle.
To learn more about this topic, please reach out to the authors:
Growth Planning and Strategic Advisory Practice Leader, GHJ
Head of Capital Advisory, Intrepid Investment Bankers