Mastering financial management in unpredictable times

Who knew the “new normal” would be so extraordinary? Few could have predicted the range and extent of challenges which would face businesses emerging from the pandemic coupled with recent geopolitical unrest. Even that underplays the scale of the issue since many uncertainties over COVID-19 persist. More lockdowns in China announced in May for example will have an impact on the economy and global trade for months to come.

From applying a critical lens to a company’s supply chain to unearthing vulnerabilities; to selling loss-making parts of an enterprise; to restructuring profitable ones thus enhancing group value to future buyers and customers; Graham Bushby, Chair of RSM's European and Global Restructuring Groups, explores the options available for businesses in an uncertain climate.

The impact of record-high inflation

Understandably, central banks failed to predict world events which are now impacting inflation levels and being felt across the globe. As late as November 2021, the Bank of England (BoE) forecast inflation would hit 5% in the Spring but then fall back. By the BoE’s next report in February, the peak had increased to 7% and again was expected to decline in the following months. In its most recent update in May, the BoE now forecasts that inflation will hit 10% this year and not return close to its 2% target for around two years.

To a greater or lesser extent, it’s a similar story across much of the world. Inflation is 7.4% in Germany and the Euro area, 8.3% in the US, and 6.8% in Canada.

With that comes rising interest rates. The Federal Reserve in the US recently announced the biggest hike in rates in over 20 years; the UK has now seen four consecutive rate rises, pushing borrowing costs to the highest level since early 2009; and even the European Central Bank is expected to raise its rates in July, for the first time in a decade.

Of course, interest rates are still historically low. However, the increased cost of servicing debt for the highly leveraged households and businesses will be significant; it only needs a half per cent rise to potentially double repayments. Interest rates are also likely to climb higher in the months to come with no immediate relief in sight.

More fundamentally, interest rates and inflation are symptoms of the critical challenge facing many businesses: logistics and shortages of supplies, including labour. Although not caused by it, these have been exacerbated by the war in Ukraine. On top of pandemic disruptions and the war, we can add a trend towards increasingly protectionist policies and restrictions on trade across many jurisdictions well before the first Russian sanctions came into place.

Whatever their source, these shortages in supplies and labour are pushing up prices. They are not only adding to costs but are also limiting revenues as businesses struggle to get materials to meet demand. As an example, shortages of semiconductors have been well publicised. Issues in other industries, such as real estate, where developers cannot secure materials to finish and sell properties to fund further building phases, have been no less acute. Landlords in the UK will likely be impacted by the new EPC legislation which may come at a cost higher than the underlying property is worth, thus affecting asset portfolios and/or balance sheets, as well as banking covenants. If inflation and interest rates drag economies into a potentially global recession, these problems will only increase.

With so much uncertainty, there has rarely been a greater need for organisations to re-examine their underlying business models. The numbers of corporates looking to restructure are growing fast. Doing so can not only enables struggling enterprises to address losses and forge a way forward but enables others to take advantage of the opportunities that a fast-changing environment presents. Businesses that do not address these issues will fall by the wayside.

Moving forward

To truly take advantage of these opportunities, it involves businesses being willing to review, reset and rebuild.

Reviewing the existing business involves establishing the new cost base in an inflationary environment; reviewing contracts, looking at senior management plans and incentives (such as share incentives in the light of current valuations); calculating free cash flow, taking into account creditors’ terms; and establishing what the new normal is across staffing levels, funding and operational costs.

Many have already done this work, but it is iterative and must be constantly monitored and adapted for fluid change. Increasing inflation, unstable supply chains, evolving valuations, and changing markets require repeated reviews to ensure the underlying business model can withstand changing circumstances. 

That review will inform the options available to management to reset the business. The options will vary as widely as the challenges each individual company is facing. It may mean seeking new suppliers to strengthen supply chains or reducing overheads. It could mean exiting loss-making contracts for those who do not pay; with many being reluctant to chase payments in hard times. A customer who does not pay is not a customer but an overhead.

Resetting may also mean strengthening the balance sheet to maximise investment or to ensure a more efficient deployment of capital, and it could mean looking at alternative funding options. While interest rates are rising and high street lenders are growing more cautious, there are significant opportunities among second-tier lenders with private equity and venture capital desperately looking for good sources of return.

Again, the process is likely to be iterative. Repeated reviews may mean further action is required, or initial changes may not produce the desired results. What is important is that management identifies changes and responds proactively. This is where independent professional advice will be invaluable, bringing a fresh pair of eyes willing to challenge assumptions and historic approaches, including long-standing practices which are no longer fit for purpose in today’s climate.

The need for third party expert advice becomes even more important when more drastic action is required: perhaps selling off loss-making parts of the group or even profitable ones to provide additional finance for the core business. Accelerated sales are increasing both among those businesses struggling in the new environment with their current cost base and among owners, who after the stresses of COVID-19 and continuing global economic uncertainty are looking for a quick sale while valuations are still high. Independent professional advice can ensure such businesses are as attractive as possible to potential vendors which will help deleverage the underlying business.

Opportunities to rebuild

Reviewing and resetting a business model is about identifying not just mitigations but opportunities from the current upheaval. The ability to identify and enact opportunities to rebuild is key.

Rebuilding requires a plan for the future of the business. This is crucial to providing direction and purpose in these uncertain and unstable market conditions. Getting there may include entering new markets, hiring personnel, or acquiring complimentary businesses. Where organic growth is hard to achieve, acquisitions can provide a route to increased revenue without adding so much to overheads; or bringing critical supplies in-house to eliminate risks in the supply chain. For every sale, there is a buyer, but at what value. The stronger the business model, the higher the value.

As ever, significant changes bring risks, and businesses must continually review and reset their plans as situations evolve. Even with advice, they will not always get it right first time. But the bigger danger comes by not acting at all. The common denominator in many failed businesses is a failure by management to react to changes around them. In a fast-changing environment, few can afford to simply stand still.

Author

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Graham Bushby
Partner
RSM UK