How to prepare your business for an economic downturn

You've probably noticed there’s a bit of doom and gloom around the economy at the moment – but it doesn’t have to be a dark time for your business. Here’s how you can prepare for the challenge ahead.

We won’t sugarcoat the situation. It’s no secret that consumer confidence is trending downwards right now, with a combination of record inflation and rising interest rates leading people to tighten their purse strings. 

The most recent Westpac-Melbourne Institute Index of Consumer Sentiment and ANZ-Roy Morgan Australian Consumer Confidence Rating surveys paint a bleak picture of consumer sentiment, particularly amongst mortgage holders, with plunges comparable to the early days of the COVID-19 pandemic and the global financial crisis in 2008-09. 

It’s not a localised phenomenon, either, with consumer confidence in the US and the UK also hitting record lows, as a result of prices rising considerably faster than wages.  

As a result of these trends, discretionary spending is expected to reduce significantly, both in Australia and abroad. 

“But Jason,” I hear you cry, “my business relies on that discretionary spending!” 

It’s true that retail businesses are typically the first to experience the impacts of an economic downturn, and we’re certainly seeing this with our eCommerce clients. 

But the good news is that there’s no need to panic. In fact, panicking is probably the worst thing you can do in times like these. 

What you do need to do is prepare – and you can do that by keeping a cool head, taking stock, and adopting an analytical approach to what might be coming down the pike.  

With potentially dark clouds on the horizon, here’s how you can fortify your business against the storm. 

In this article: 

Scenario plan with a three-way financial model

When life gets you down, the first step is to organise a three-way – a three-way financial model, that is. 

It’s a tool used for budgeting and planning purposes, that consolidates your Profit & Loss, balance sheet and cash flow projections together so you can forecast your business’ financial future. 

It’s typically used for strategic budgeting, scenario analysis, understanding cash flow gaps and capital raising. The integration between the three statements allows you to see how the various line items impact each other, and project how certain scenarios will affect your bottom line. 

In this case, we want to model three scenarios: 

  • A modest downturn (15 per cent decline in revenue) 
  • A more severe recession (25 per cent decline in revenue) 
  • A depression (50 per cent decline in revenue) 

This will guide a decision-making framework to help us prepare and plan for each scenario with regards to: 

  • Restructuring operating costs
  • Pricing decisions
  • Cash flow gaps and access to capital

The purpose of this is to prepare for the worst. If my business did reduce its revenue by 50 per cent, what costs would I need to cut?  

It can tell us what levers we need to pull within our business to optimise our profit; get back to breakeven; or increase our cash balance to make sure we don’t go broke. 

It takes some skills to build a three-way financial model – as well as being an Excel wizard, it helps to have an understanding of accounting, and the industry knowledge required to know how the various inputs should affect each other.

Watch our demo below on building a three-way financial model below:

With a three-way financial model, you can plan exactly how you would respond to each scenario. That way, if one of those scenarios occurs, you’ll be prepared – rather than expecting everything to be fine, and making panicked and irrational decisions when things don’t turn out quite like you expected. 

If you need any help building your model, reach out to us at SBO

Improve your working capital management 

As every business owner knows, just because you’re making a profit doesn’t mean you’re flush with cash. Instead, your cash is most likely tied up in working capital. 

That’s why you need to focus on unlocking that cash with effective working capital management. 

Working capital is split into three main functions of your business: 

  1. Accounts receivable 
  2. Inventory 
  3. Accounts payable 

Start by looking at your cash conversion cycle. This is a very simple metric that measures the liquidity of your business operations in terms of the amount of days it takes to convert your profit into cash. 

As a rudimentary mathematical equation, it looks like: 

The cash conversion cycle is like golf – the lower the number, the better. 

Let’s take a closer look at how we can drive that number down. 

Accounts Receivable Days

First off, do a risk assessment of each of your customers and their ability to pay their current invoices. 

If there are any laggards, pick up the phone and get them to pay their outstanding account. If you know they’re already doing it tough, you can offer them a payment plan – get them to commit to a small, affordable weekly repayment on direct debit (via credit card to help their cash flow). 

It’s important that you rank your customers by their credit risk, and strategically offer financing to certain customers only. In other words, don’t give good credit terms to higher risk customers that are likely to go broke before you get your money. 

You also need to secure your contracted revenue. Review your existing terms and conditions, and ensure you’ve built in robust termination clauses so you have plenty of notice if customers decide to cancel their contract with you. 

It’s inevitable that some customers may ‘fire’ you, especially as pursestrings get tight. Just make sure you have plenty of notice to prepare for that scenario. 

Remember, too, that your accounts payable are someone else’s accounts receivable, so you can expect to be on both ends of these conversations as businesses circle their wagons. 

Inventory Days 

You’ve probably heard of the 80-20 rule, or the Pareto Principle. It’s the idea that 80 per cent of outcomes result from 20 per cent of inputs. 

In retail, the goal of the 80-20 rule is to find your most productive products, and make them your priority. 

To do an 80/20 analysis of your SKUs, rank them by: 

  1. High volume, high percentage margin 
  2. High volume, low percentage margin 
  3. Low volume, high percentage margin 
  4. Low volume, low percentage margin 

Clear out SKUs that fall into the d) bracket at a discount to make room on your shelves and in your warehouse for the products that actually sell, and focus on re-ordering only the SKUs that fall into the a), b) and, to a lesser extent, c) brackets. 

The objective is to focus on products that move quickly, and maximise gross profit dollars to the business. 

The same principle applies in service industries – in that case, it’s about focusing on your services and clients with higher margins, and ditching the ones who aren’t worth your time and effort.

Accounts Payable Days 

While the goal is to decrease Accounts Receivable Days and Inventory Days, we want to get our Accounts Payable Days up. 

Lean on your creditors where possible, and start with your big suppliers. Whereas you ranked your debtors by your credit risk, rank your creditors by their ‘blue chip’-ness – which of your suppliers do you think has a balance sheet healthy enough to wear slower payment terms? 

Engage in active conversation and have an open dialogue with your creditors. Be honest about your situation. If you have 15 days to pay, don’t be afraid to ask for 30 – the worst they can do is say no. 

Depending on your situation, you can also talk to your landlord about a rent deferral. 

Restructure costs and ‘rightsize’ 

When times get tough, it’s inevitable that some businesses will have to cut their costs and even downsize their teams. There’s no denying that these are tough and often emotional decisions, which is why it’s best to plan ahead and use a framework in order to stay rational. 

It can be helpful to think of cost cutting in terms of fat, muscle and bone. 

Cutting fat 

This is the easiest and most painless place to start. Cutting ‘fat’ costs should have no major negative impact on your business – these are the nice-to-haves; the costs you got used to and haven’t had to question because times for your business have been good, and your growth has masked their inefficiency.

‘Fat’ costs include: 

  • Unprofitable products or customers. Never waste a good crisis! Take this opportunity to rid yourself of accounts and products that aren’t pulling their weight. 
  • Superfluous software and subscriptions. Watch out for Death by SaaS – are you drowning in subscription fees for products you used once and never used again? 
  • Travel. We’ve had plenty of practice with cutting travel already… 
  • Employee leave. If employees have some leave built up, now could be a good time to encourage them to take it. 
  • Meals, entertainment, and non-essential allowances. 

Cutting muscle 

These are the things that will impact you and hurt you in the short term. They may restrict your growth, or increase your workload, but the damage won’t be permanent – you can build back up. 

The types of cuts that will temporarily hurt your trajectory include: 

  • Paid marketing and advertising. This depends on your business model – some eCommerce companies simply won’t be able to consider cuts here, because they derive too much of their revenue from paid marketing and advertising, while other businesses may find that they’re currently spending money on customer acquisition that they can afford to cut back on. 
  • Business development. We’re talking about general partnership and business development opportunities here that you can pause and come back to later – not sales. 
  • Reducing the number of projects you’re working on to only the most critical ones (or one). 

Cutting bone 

These are the cuts that will hurt your long-term viability. They will cause great distress now, and they have the potential to permanently damage your business. They are a last resort for survival. 

We’re largely talking about layoffs and downsizing here. There are three approaches you can take to this – you’ll have to use your judgement to decide what works for you in your circumstances. 

  1. The drastic one-off cut. Under this scenario, you aim to make one drastic cut to downsize your team to the people who are essential for its survival, and build back up once you come out the other side. The idea here is that slowly and unpredictably cutting your team hurts your culture and efficiency, so it’s better to just rip the band-aid off. 
  1. Trimming. This is the most common approach, but potentially the most harmful to culture. Under this approach, you rank roles from most critical to least critical, and let the minimum number of people go incrementally, based on the business’ cash needs. This might be the most coldly rational approach, but the problem is that it breeds fear and uncertainty. Productivity drops as people start to wonder if they’re next, particularly if they don’t see an upward trend in your prospects. 
  1. Everyone stays, but reduces their hours or takes a pay cut. This could involve temporarily moving everyone to four days across the board; dropping wages by 10 to 20 per cent; or making much larger cuts, but topping employees up with equity. It may not seem like your team would go for this, but depending on your situation, you may find that people are willing to do this to keep their jobs and help the business survive. 

Regardless of which method you choose, the key is to communicate early and often. Don’t leave people wondering. If you‘re choosing between options, you can even discuss them with your team to see what everyone would prefer, and if there are lay-offs or stand-downs coming, give people as much notice and information as possible. 

Ultimately, you should find that planning for all of these doomsday scenarios has a silver lining, in that it will build resilience in your business. After all, some of the best businesses in the world were built in recessionary environments – so an economic downturn doesn’t have to be your business’ downfall, if you play your cards right. 

Whatever happens, if you follow these practices, you should find that you come out the other side stronger and more agile. 

And of course, we’re always here to help – so just reach out to us here at SBO Finance if you need help navigating the waters ahead. 

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