By Aaron Ackerman, Consulting Executive
Many companies in the oil patch found the ink barely dry on their 2015 Strategic Plans when the reality of falling oil prices hit home. Even companies not directly tied to the energy sector are now wondering what impact $50-oil will have on the coming year.
This uncertainty leads to more questions than answers. “Are we at the bottom yet?” “How long will it last?” “How are my customers going to respond?” “What is the bank thinking?” “What if my bigger competitors use this opportunity to take market share?”
In this first part of a two-part edition of The Owner’s Calendar, we’ll provide guidance on how to manage your business in uncertain times.
Managing My Business in Uncertain Times
- Stress test your business model.
Guarding against over-optimism. Leading up to the U.S. housing/mortgage crisis in 2008, the models that lenders and ratings agencies used to determine the pricing of those infamous mortgage-backed collateralized debt obligations (“CDO’s) were seriously flawed. The models had built-in assumptions that median house values would go up indefinitely. Never flat. Never down. Once housing prices began to decline, there was a cascading effect through the entire financial system.
Had the underlying financial models been tested for the potential effect of flat or declining house values, it is likely that the CDO’s would have been more appropriately priced to reflect the actual risk . Instead, those risks were completely ignored and overlooked.
Predicting the unpredictable. You can never accurately predict every potential threat to your business, but you can still plan for uncertainty. In March of 2011, the Japanese Tsunami devastated the northeast coast of Japan. Like most Americans, Oklahomans sympathized with those Japanese citizens who were so dramatically affected, and we sought ways to help.
However, it quickly became clear that this natural disaster would have a far reaching and unpredictable ripple effect on businesses across the world. For example, nearly overnight, local TV stations, including those in Oklahoma, realized that up to 25% of their revenue base was at risk because the tsunami had drastically disrupted the global automobile manufacturing supply chain. With fewer cars available to sell, local dealers and the auto manufacturers quickly pulled back on purchasing advertising on local TV and radio stations.
While it’s impossible to predict when and how these kinds of business disruptions might present themselves, it is possible to model 25% to 30% declines in your revenues in order to shine a light on the parts of your business that are most susceptible to deterioration.
Trading short-term profits for future flexibility. In some businesses, such as the oil and gas industry, an occasional down cycle is never a question of IF, but WHEN. Ironically, some leaders will still make decisions as if the good times will go on forever. They attempt to optimize profit margins by in-sourcing all functions and leveraging their balance sheets.
Stress testing your financial model will highlight the impact of these and other decisions. One owner we know in the energy sector regularly stress tested his projections to simulate the impact of a 30% drop in revenues. Analyzing these tests led him to maintain a 2:1 ratio of field employees to third-party contractors. Similarly, he chose a similar ratio of owned to rented field equipment. These decisions greatly increased his flexibility to quickly reduce operating costs by 25% to 30% without the pain of layoffs or idle capital assets with fixed loan payments attached.
- Cash is Still King.
Reduce the investment in working capital. In times of uncertainty, you can never have a big enough cash cushion. Use this time to redouble your focus on reducing past due accounts receivable balances, improving billing practices, and reducing inventory.
Place your bets carefully. A Las Vegas hotel and casino CFO recently relayed his experience of making too many large investments at one time. Before the recent “great recession,” his company was doing very well and was creating free cash flow at a healthy rate. Rather than accumulating more and more cash on the balance sheet, they proceeded to deploy cash into capital projects and other large-scale investments, which in turn further leveraged their balance sheet and depleted their cash cushion.
When the recession took hold and travel to Las Vegas dropped dramatically, operating cash flows turned negative, and servicing debt and meeting bank covenants became major concerns. In times of uncertainty, winners do not quit investing in their future, but those investments should be made carefully and at a manageable pace, always maintaining an appropriate cash cushion.
In Part II of this series, we will continue our discussion of managing your business in uncertain times: Facing Reality, Encouraging Innovation from the Organization, and Flipping Challenges into Opportunities.