A Tsunami of Bad Debt is rolling to our shore, to drown unexpected parts of the economy — and how to survive
Bankruptcy rates are closely linked to GDP volatility. In OECD countries the regular insolvency rate is around 8%. Though dramatic for the individual firms, this is a healthy process for the economy, as part of economic Darwinism, selecting the weakest market participants. Companies, failing to adapt to changing market conditions as a result of inertia, are eliminated, opportunities are opened for new ventures. The ratio of defaulting firms can change significantly with a decrease in GDP. In these moments, “not-so-fit-companies” are more likely to face turmoil and distress, once, conditions get harsher and the benchmark for survival is raised. This is intuitive.
An earthquake deep below
Corona and the associated lockdown of public life has hit the economy in at an unprecedented level. Corona is putting the economy in a state of emergency, also changing the underlying for bankruptcy conditions. Whereas the amplitude of the crisis is unprecedented, the impact on economy came very sudden, yet with a little warning ahead, allowing executives, to prepare their firms for the storm ahead.
Business media, as well as Newsletters of any consulting service provider, are advocating measures on the level of the firm, to build resilience and make it through the crisis.
A core discipline for executives is to retain cash and liquidity. Tools at hand are a.) performing on accounts receivables, and b.) deferring payments on accounts payable. To put it in the words of Pirates of the Caribbean’s Captain Jack Sparrow:
“Take what you can and give nothing back.”
This principle works well for Pirates, consultants, and helps individual firms to maneuver through situations of turmoil and distress. Yet, if this pattern of behavior becomes dominant, damage to the economic eco-system is inevitable and the number of economic causalities will be unnecessarily high. If not paying bills becomes normal, a domino effect kicks off.
According to data released by Sidetrade, a Paris-based firm, helping businesses with customer engagement, cash management, and invoice collection, the amount of money, more than 10 days overdue has grown by approximately 50% in the European market place, since the WHO announced the case of the pandemic on March 11th.
Upstream is, where it will be dangerous
The higher a company is situated in an industries’ value chain, the stronger it will be hit by the economic consequences of the Corona-effect. Deferring accounts payable means pushing risk from the own balance sheet to suppliers. Unlike situations of individual bankruptcy, the systematic preservation of liquidity through deferring cash-outflow throughout the economic eco-system is consolidating the economic risk of the crisis upstream in the value chain. Relatively healthy firms, normally far away from the risk of bankruptcy, may face immediate and severe turmoil in the near future.
Bankruptcies will hit companies relatively unexpected and hard.
Executives, shareholders, and providers of liquidity are blindfolded in their risk assessment, as traditional instruments of assessing default risk are not capturing this effect.
Rough waters ahead — how to manoeuvre through the storm
- Governments are well-advised, to distribute liquidity to the economy, in order to hedge for the systematic effects of the crisis. However, this comes at a price. The IMF prognoses an average level of deficit of 11% of GDP for advanced economies — considering no more lockdowns in the second part of the year. Debt will climb up to 105–122% of GDP, or $66trn by end 2020. This will create budget challenges for governments to come. To pay off debt, governments are known to turn to faster growth, higher taxation, harsh budget discipline, squeezes on interest rates, and higher inflation. It will be for future generations to understand, if these measures are in line with expectations for governmental subsidises to help SME firms to return to business and also provide sufficient funding for the post-corona healthcare system.
- For the executive management, the answer is a bitter pill. Retaining liquidity, by performing on accounts receivable and defer on accounts payable is still the right measure on the individual level, but as outlined above, very, very unhealthy for the eco-system, if applied by too many market participants. High situational awareness, for liquidity and collection of claims, is crucial. Pursuing other forms of funding (loans, capital increases, convertibles, leasing, etc.) may provide liquidity reserves, which may become crucial. Also, adjusting payment terms, to e.g. collecting up-front payments, or incentivizing customers to pay in time, to void risk of bad debt might be advised.
- For debt and equity investors, differentiating between liquidity and Profit and Loss statements is more important than ever. Though higher provisions for bad debt also must be taken into account, the expectation is legitimate, accounts will normalize, once the effect of Coronavirus on the economy will diminish.
7 critical management techniques for survival
Times to come, expose businesses to unprecedented troubles. Management is, more than ever, to challenge the assumptions of its strategy and going concern. Whereas no “one-size-fits-all” solution is available at the time, 7 basic steps, complementary to excess reserves in liquidity, can help to keep control through the storm:
- Seeking close alignment with all stakeholders may be key to mitigate the impact of the crisis
- Performing sound leadership can help to vitalize the organization and also find acceptance even for harsh decisions
- Strongly embedding a firm in the economic eco-system creates resilience
- Applying scenario planning, and adjusting the firm to different possible situations to come, keeps options open for the executive management
- Foster situational awareness, to anticipate the “next wave to come” before it hits the firm
- Closely analyze the firm, to understand, which areas are crucial for survival, which parts can be divested, with limited effects for the organization, which areas are growing, which are subsidized through other areas, etc.
- Foster diversity in managerial processes. Call for outside assessments, have own ideas and opinions challenged, include managers from different levels and backgrounds into the planning process, delegate operational authority throughout the organization, foster adaptability, and agility.
Times to come will call for experience on the executive level and a strong effort from the whole firm, to master the economic challenges. Teamwork, endurance, and resilience of the organisation are the key resources to build on.
Find the original article at koljarafferty.com