Escaping Bankruptcy - The pandemic seems like it is here to stay, but how can firms make sure its effects aren't?

May 30, 2021 | Issue #4

Economic downturns have caused cash flow implications across the extended supply chain.

With almost all major economies of the world coming to a standstill due to stringent lockdown and social-distancing measures, most organizations are reeling for cash. To avert crisis, organizations are immediately switching to a survival mode to take care of their own finances, transferring pressure from supplier to customer or vice versa. This has led to the tremors of disruption being felt across the entire supply chain.

So, eventually who along the supply chain takes the brunt of tighter financing needs?

In the short term, as firms tighten working capital policies, the pressure of financing needs is transferred to more vulnerable partners along the supply chain. Survival has depended on financial resilience of trading partners, giving larger organizations the ability to withstand the pressure of the pandemic. Given that SMEs have fewer resources – lower cash reserves/cash buffer (in days), unstable cashflows and struggle for profitability – when compared to their larger counterparts, they are more often than not more vulnerable and end up having to be the ones that face liquidity shortages and bankruptcies. This condition is further aggravated by the unwillingness of banks to lend to non-reputed firms during times of crisis.

Half of small businesses only have a large enough cash buffer to allow them to keep business going for 27 days. Those within labor intensive industries, have even less of a buffer, with restaurants only having 16 buffer days on median.
Hence, SMEs and youth-led firms are at a higher risk of permanently shutting down in coming months.

In order to mitigate liquidity shortages and avoid unnecessary bankruptcies in the nearest future, less-resilient organizations can adopt a range of temporary measures from – sustaining demand to working capital management and cost and capital restructuring. To read up on sustaining demand amidst crisis, look up our article on CUSTOMER RETENTION.

In this article, we explore:

  1. Working capital management tactics that can be deployed to bridge short-term financing gaps and weather off the effects of rising  financial pressure from the more powerful upstream and downstream supply chain partners.
  2. Cost and capital restructuring to ensure firms are not incurring expenses in the absence of business. Reducing variable costs, fixed costs as well as revisiting capital reinvestment plans are some of the tactics we explore.

1. Managing day to day working capital finances is one of the most crucial steps to tide over the crisis, whilst bearing in mind, its effects on the extended supply chain.

As cashflow becomes the need of the hour and takes precedence over profitability, businesses are having to shift focus from the income statement to the balance sheet, deploying measures to release cash tied up in inventory, receivables and payables

INVENTORY: Revisit demand plans and identify optimal stock buffer to avoid dislocation of inventory – an excess results in a cashflow struggle and a shortage leads to lost business.
A. Improve the accuracy of demand forecasts by leveraging technology

I. Improve fill rates

Accurate demand forecasts enable early identification of optimal stock levels, re-order points and lead times. Having the required stock in time drives more revenue through improved fill rates and service levels, whilst keeping inventory holding costs down. It avoids the loss of business caused by an unavailability of products.

On the other hand, multiple firms that relied on outdated forecasts expecting usual inventory turnover in order to drive revenue and create space for new products have ended up closing locations owing to plummeting sales leading to inventory backlogs while additional inventory is en-route to them through vast supply chains.

For example, local independent grocery stores that carefully predicted the increase in demand owing to the pandemic have managed to restock the right products (mostly shelf food and sanitary products) at unprecedented speeds and drive revenue up.

B. For products with rising demand, update safety stock parameters and brace for recovery mode

I. Update safety stock parameters

In the short-term, as consumer demand shifts from wants to needs, essential products experience a surge in demand. Some of these products are at a risk of facing raw material/product shortages due to import restrictions, plant outages and lockdowns. Hence, inventory safety stock parameters need to be revised to reflect increased demand as well as supply-side volatility.

For instance, Sri Lankan consumers have begun to hoard medical supplies, resulting in massive shifts in demand for pharmacy retailers. However, countries from which such medicines are largely imported, such as India are facing spikes in infections and are likely to shutdown supply. Hence, retailers will need to look at securing additional inventory faster prior to shutdowns, or look for alternate suppliers in other regions or explore the potential of local pharmaceutical manufacturing (subject to availability of lab facilities, non-patent drugs, clinical trials and timelines) to ensure undisrupted product availability.

In addition to the product itself, other mission critical items that enable continuity in operations should also be stocked up – crucial raw materials for production (even if small volumes), personal protective equipment, such as masks, gloves, and gowns and key replacement parts and maintenance products, such as food-grade lubricants for critical plant equipment.

II. Brace for recovery mode

Failure post COVID for some has mainly owed to an overestimation of sustained impact, both systemically and cyclically, as the intensity of the shock fueled widespread economic pessimism, breaking many records (negative) in the process. However, as evident from historical pandemics, economies and demand eventually stabilize at some point and the ones that emerge as winners are those that brace themselves for transformative recovery.

For example, a local spice manufacturer states that COVID certainly had an adverse impact on them; however, business picked up relatively soon after even amidst curfew restrictions as their product was an essential. Competitors who had overly downsized operations by closing plants and laying off employees, were unable to take advantage of the positive spike, whilst they, who prepared for recovery were able to bring supply chains and inventory back into balance much faster than those who waited to see signs of recovery to act on it.

C. For demand choked products reduce inventory burden

I. Reduce inventory burden by returning excesses, avoiding further inventory creation and wastage

Where inventory hasn’t contributed to margins, SMEs should collaborate with suppliers to explore the possibility of, returning shipments/loads of raw material that haven’t reached ports/warehouses, returning unused raw material sitting in warehouses, hold off automatic material requisitions for the future and avoid dispatching into manufacturing lines for further production to avoid adding more inventory burden (both raw material and finished goods).

For more perishable products, inventory levels need to be adjusted to suit revised demand as waste is a prominent cause of cost where markets remain difficult to access.

For example, a local retailer selling imported gourmet prep food such as smoked salmon, overseas grown fruits, faced severe wastage given the shorter expiry periods and high purchase cost of such products. As consumers switch to be more conscious, they are purchasing more long lasting and affordable products.

II. Assessing alternative uses of inventory

  • Finished goods inventory – assess the possibility of selling it in other regions. For example, if international markets are the main focus, redirect to domestic markets or to less affected geographies.
  • Raw material inventory – assess products facing a surge in demand and evaluate the possibility of creating it with our raw materials. For example, alcohol being used to make sanitizers.
  • Direct channels to reach consumer – if inventory is trapped in physical stores, review the possibility of advertising and selling online.

III. Consider new consignment arrangements

Approach key customers to identify if they are able to hold inventory on our behalf, or if vendors are willing to put supplies in our plants on consignment. This could be a win-win, so each party has a protective buffer in the event of a disruption while keeping inventory holding cost a minimal.

RECEIVABLES: Generate faster cash flow from receivables – a pre-earned cash source.
A. Assess customer resilience based on region and industry within which it operates

Gauge impact on customer geographies, industries, subsectors and assess recovery period.

It is not uncommon to find businesses at both ends of the spectrum.

For example, some industries like healthcare and essential supplies experience minimal or positive impact, while others like airlines and capital goods have been badly affected.

For those that are badly affected, assess the long-term impact of the outbreak while some industries might take a longer time to come out of the crisis and the ensuing recession, others may bounce back quickly. Subsectors could also behave differently within an industry. For instance, automotive subsectors might follow very different recovery trajectories: the maintenance and repair of vehicles could recover more quickly, than their manufacture or sale.

B. For customers in impacted industries, re-assess credit risk and customer lifetime value

Segregating those who are unable to pay from those who are able to pay

Re-assess customer credit risk based on past credit history, the COVID-19 impact on their business, government support and delinquency risk.

For instance, this could be an opportune time to focus specifically on clients who have benefitted from government stimulus packages.

Leverage advanced analytics tools that can use inputs such as past payment behaviors and company revised financial health to predict a company’s likelihood of paying overdues.

C. Re-assess potential lifetime value of customers

Identify the potential business a company would receive from a customer

Identify loyal (one-time or recurring) and key customers (could their decisions disrupt us financially), how much business they currently account for (percentage of overall revenue) and the future of their business with the company.

Does a single customer account for greater than 25% of our business?

D. Devise personalized strategies for each customer segment

A one size fits all approach often results in longer Days Sales Outstanding. Hence, a personalized strategy for each customer segment is recommended.

E. Leverage technology to improve dues collection

Digitize payments to ensure customers can pay you from wherever they are – SMEs are forced to use their agility to be more responsive to the crisis, as they do not have built-in resilience to fall back on. Taking leapfrog approaches is essential to help them stay alive and digitization of payments is essentially one of them.

Improved visibility to cashflow decision makers – Ensure that all decentralized information is made available on a single dashboard with KPIs to monitor (pre-COVID versus post-COVID KPIs: current ratio, acid test ratio, inventory turnover, cash conversion cycle, receivable turnover).

For example, a B2B company consistently faced a high level of overdues on website orders due to a discrepancy in volumes. This was caused by a lack of information and clarity among responsible teams – IT, Sales and Collection teams. Establishing a centralized information system increased visibility across all three teams and helped the company with a significant reduction in overdue accounts. This also boosted morale among collection team members by reducing the time they spent working repeatedly on the same issues.

SUPPLIERS - Collaborate with suppliers to establish optimal revised credit terms and reschedule payments accordingly.
A. Map supplier resilience and how crucial they are to our business to tailor payment strategies

Review vendor profiles to assess their resilience based on region, industry and subsector within which it operates. Then conduct a supplier risk analysis to evaluate their ability to react quickly and maintain supply continuity. Supplier cruciality would depend on level of diversification of supplier base, our level of reliance on them and their replaceability. Then create a payment strategy tailored to each of them.

B. Leverage technology to ensure invoices are foolproof – paying only for services you used
  • Simple automation of the payable process from recording and auditing purchase orders, invoices, requesting approvals and flagging missing documents helps reduce staff burden and chances for human error.
  • Reviewing raw material stock for quality issues such as damages/expiry or non-required supplies that are still within the return period can also help reduce total bill.
  • Identify what alternate suppliers are offering as concessions in times of pandemic and negotiate for similar terms, or inform suppliers of the inclination to switch.

2. COST AND CAPITAL RESTRUCTURING TO AVOID HAVING TO PAY FOR EXPENSES THAT FALL DUE DESPITE A LACK OF BUSINESS.

COST RESTRUCTURING – Firms should focus on both variable and fixed costs
A. Reduce current variable cost spend
  • When labour is a significant cost line, consider avenues that might help reduce spend to avoid getting to a situation where layoffs are required.

For example, while there are typical variable cost-reduction levers, such as imposing travel bans and non-essential meeting restrictions (which might already be in place as a way to manage employee safety), imposing hiring freezes, and placing restrictions on discretionary spend like entertainment and training is essential. 

  • Firms should look for opportunities to reduce contract labour and re-distribute work to the permanent workforce.
  • Encourage employees to take available leave balances to reduce liabilities on the balance sheet and, if necessary, consider offering voluntary, or even involuntary, leave without pay to preserve cash.
B. Reduce overall fixed cost spend
  • If rental agreements are approaching renewal, look for cheaper and smaller locations and encourage employees to work from home to reduce rental, electricity and other corporate level expenses.
  • In times of uncertainty, firms should aim to swap fixed costs to variable costs wherever possible—preserving core business while increasing flexibility on fringes.

Selling assets and leasing them back, expanding the use of contract manufacturing, transportation fleet leasing and third-party warehousing are some of the ways to raise emergency cash.

CAPITAL RESTRUCTURING – With cashflow forecasts in mind, firms should consider what’s really necessary for the near term.
A. Revisit capital investment plans
  • It is crucial to identify capital investments that can be postponed until the situation improves, investments that need to be entirely reconsidered and capital investments that are essential for rebound or for creating competitive advantage.

For example, most firms are cutting down non-critical expenses like research and development whilst investing on technology and digitization platforms.

In the more medium term, organizations would need to build resilience by looking beyond its own enterprise – collaborating with key trading partners to transform the extended supply chain to a more agile and transparent value chain. In doing so, businesses will have to safeguard the interests of partners as well as its own employees. To read more, await our next issue.

References

“Why The Global Economy Is Recovering Faster Than Expected” – Harvard Business Review, November 2020

“Managing and monitoring credit risk after the COVID-19 pandemic” – McKinsey, July 2020

“Managing cash flow during a period of crisis” – Deloitte, Mar 2020

“Receivables as a mission critical cash source” – Mondaq, July 2020

“Food & beverage inventory management”- Plante moron, March 2021

ABOUT THE AUTHOR

Seyeda Mowhiba is a Consultant at Stax and has been with us since 2016. As a holder of ACMA, CGMA, UK and four world awards in Financial Management and Strategy, she has led multiple projects assisting companies across diverse industries on business strategy formulation, process improvement, and financial modeling. Prior to her role at Stax, she worked at Moody’s Analytics and Dilmah.