Adjusting to Downturn Positions Companies for Rebound
by SCOTT CONNELLA
Is the economy poised for a rebound?
If so, many strong small and middle-market companies stand ready to take advantage of better times. They hold important lessons for other businesses now struggling to keep in balance.
No one expects a repeat of the heady economic growth of the middle and late 1990s, in large part because no one knows what to make of the economic impact of an expected war with Iraq.
But there is growing evidence that many small and middle market companies the backbone of the economy of Southern California are ready to prosper should better times come this year and next.
How did these strong companies weather the recent downturn in the economy? More important, how are they positioned now to take advantage of any uptick?
Overall, the survivors got this far in good shape by watching their pennies, emphasizing profitability, beefing up their management teams and taking advantage of the recent fall in interest rates.
Put another way, the healthy survivors withstood the collapse of the technology bubble and subsequent tremors in the economy by going back to the basics of running a successful business. In the face of uncertainty, they turned their gaze inward and strengthened the crucial elements of their business operations with old-fashioned, tried-and-true management techniques.
Back to basics
Many companies adjusted to the slowing economy by paying down lines of credit and reducing leverage, which can magnify risk in uncertain times. Many found better ways to amortize equipment costs, saving money and cutting taxes. Many converted leasehold interests in real estate into ownership interests by buying with long-term debt, often with positive results for cash flow. Many refinanced long-term debt secured by real estate and, sometimes, by equipment.
Companies cut labor and materials costs by modernizing supply and inventory procedures and by laying off staff to meet slackened demand. They resisted new investments in technology hardware, choosing instead to wring additional efficiencies out of existing software systems for example, by fine-tuning information programming to produce better data on their back-office and production and distribution systems.
The more far-sighted of them contracted with outside accounting firms to produce audited financial statements. This is a major step involving a significant outlay $10,000 to $40,000, often more. But it brings big benefits: It gives a company the clearest possible idea of its current and historic financial position and, not coincidentally, more clout with outside financing sources such as lenders. An outside auditor can also help the company identify and implement new strategies for tax savings.
To their surprise, many companies also found themselves holding the upper hand in the job market for high-level executive talent, probably for the first time since the beginning of the great economic expansion of the 1990s. When that expansion ended three years ago, the job market filled with sophisticated senior-level executives on both the financial and operational sides. Small and middle-market companies gained a unique opportunity to recruit executive teams whose skills might have been beyond their reach only five years ago.
This new blood at the executive level now enables many strong small and middle-market companies to enjoy the strategic thinking that comes with a chief financial officer, for example, in place of a controller, or a chief operating officer in place of division managers. Many now use this muscle to find sounder ways to structure their corporate finances, their operations and, in some cases, even their legal structures.
At the same time, even though many strong companies saw revenues fall between 10 and 20 percent in recent years, they increased their profitability. They used this competitive advantage to maintain and in some cases even to increase their access to debt financing with large and sometimes largely unused lines of credit.
Other companies learned to make do with significantly less debt, in part because lenders grew more cautious than they had been in the 1990s. Also, as revenues fell, companies found they didn’t need as much leverage.
Overall, U.S. corporate demand for borrowing peaked in 1993, up 40 percent over the levels of two years previously. Demand fell sharply in 1994 and again in 2000 and 2001, dropping nearly 80 percent from its levels of late 1999. It remains low by historic standards, although there are growing signs of an uptick.
Looked at from another vantage point, three years ago it was not unusual to see companies with revenues between $100 million and $500 million carrying senior secured debt equal to four times cash flow that is, earnings before interest, taxes, depreciation and amortization. Companies with revenues of less than $100 million often showed debt equal to more than three times cash flow. Now the multiple is commonly 2.5 or less.
Debt constraints aside, many strong companies now show ample cash reserves. They run lean operations backed by efficient production and distribution processes, along with powerful back-office information systems, all under the direction of highly professional executive teams.
In short, sporting new muscle, the strong survivors of the recent economic slowdown are ready to get a head start on growth should the economy take a turn for the better. And the discipline that got them through the recent past offers a potent example for any business owner contending with hard times.
Scott Connella is senior vice president and division manager of the commercial banking group for metropolitan Los Angeles for Union Bank of California. He may be reached at