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Teperature Rising:
How to Prepare for the Upcoming Credit Crunch

By Mark W. Sheffert
January 2001

A friend suggested that the next time I was in New York I should try a certain French restaurant. When I went there a few weeks ago, I discovered that it was one of those types of restaurants where everyone pretends they can’t speak English and you can’t read the menu.

As I perused the menu, I saw something called "cuisses des grenouilles" and asked the waiter what it was. He informed me in his fake French accent that it was a delicacy."No, I mean, what is it?" I asked. He then muttered under his breath, "Frog legs." Really? I had always been curious about this, so I asked him how they went about cooking frogs.

By this time, he had figured out that I was not too sophisticated, so suddenly his French accent changed into a Brooklyn one. He said that you can’t cook frogs by plopping them into a pot of boiling water like the way you’d cook a lobster. Apparently, the frogs will jump right out of the pot. Instead, the best way to cook frogs is to place them into a pot of very comfortable room-temperature water, then gradually heat the water up to boiling. They don’t know what’s hit them until it’s too late. Before they know it, they are on somebody’s plate. (I decided that they wouldn’t be on mine though.)

Later, I was thinking about what’s happening in today’s financial markets and it occurred to me that small businesses could end up like the frogs. In a robust economy, it’s easy to be tranquil and unaware of the heat turning up. Rather quietly, free-flowing cheap money is going away, sources of financing are getting tougher to find, and a credit squeeze may soon be boiling small businesses.

You don’t believe a credit squeeze may be coming? Well, wake up and feel the hot water! The following trends from Portfolio Management Data/Standard & Poor’s indicate that banks are getting stingier with their credit.

DEFAULT RATES RISING

Bank loan default rates have been steadily on the rise. On October 16, Bank of America reported that its third quarter net income fell 15 percent to $1.83 billion because its non-performing assets jumped nearly 50 percent. The next day, Bank One Corp. reported a 37 percent drop in earnings basically for the same reasons. This is happening all over the country.

As a result, lenders are tightening their standards. For instance, operatingearnings- to-debt multiples have dropped from 5.8 in 1996 to 3.8 as of September 2000. And the required equity-to-debt amounts have risen from 22.9 percent in 1996 to 35.3 percent in August of 2000. Lenders are demanding higher returns on their loans, with a 100 basis point increase in institutional loans from the third quarter of 1998 to the third quarter of 2000. And, there has been a significant decline in leveraged loan volume from 75 percent in 1996 to –9 percent in the period from April 1, 2000 to September 30, 2000.

The capital markets are in turmoil as well. Since hitting a record high in March, the Standard & Poor’s 500 stock index had dropped 13.5 percent by mid-November, and the Nasdaq Composite had plunged 60 percent, with no end in sight in the midst of the presidential election indecision. The bond market is tighter, with a collapse in the junk bond market. The number of companies postponing IPOs more than doubled in October compared to those postponing last year. Falling stock prices are also to blame for significantly slowing the number of stock-financed mergers and acquisitions. In fact, the number of M&A deals in September was at the lowest point since November 1996.

To make matters worse, this turmoil is beginning to create a slowdown in consumer spending and the first signs of a resultant decline in earnings. With less profit, businesses will have a tougher time making their debt payments. Some economists are predicting that if this credit squeeze goes on for too long and spreads too far, corporate bankruptcies will rise. It’s likely that personal bankruptcies will also rise, as the consumer savings rate is now negative.

So what does all of this fancy economics mumbo-jumbo mean to you, a small-business person up here in Scandinavia land, far away from the pinstripes on Wall Street and the big banks on the East and West Coasts? Well, it means that there’s a reassessment of risk throughout the economy that’s giving lenders everywhere the jitters. This may have a profound impact on small businesses, which are considered by lenders to be their riskier and weakest customers and will therefore be the first to feel the heat.

MAKE FRIENDS WITH THE BANKER

So what can you do to get prepared? First, don’t just sit there unaware of the water (or financial crisis) heating up or you might get boiled. There are many things you can do now to prepare yourself for a credit squeeze, if one occurs.

Be your banker’s best friend. When everything’s peachy keen, business people don’t put much effort into the relationship with their bankers, and vice versa. But if there’s a possibility of trouble ahead, now’s the time to make sure that your banker knows you well and understands your business. Providing credit is as much art as it is science, so bankers will rely on their relationship with you when deciding how much to cooperate during a financial crisis.

Stockpile cash. If a recession hits, the first thing to go will be your cash. Make sure you have at least two to three months of operating cash available at all times. This isn’t rocket science, but it does take discipline.

Get aggressive with receivables collections. Work on getting as many of your customers as you can to pay within 30 days. If you have a lot of customers 60 to 90 days overdue, get really aggressive. Assign and train someone to call these accounts, get them to commit to a payment date, and keep after them until they pay. Run reference checks on new customers to find out payment patterns in advance. You don’t need to subscribe to an expensive credit service, but just ask them for some references and check them out.

Make sure your invoices are easy to understand and that your payment terms are clearly spelled out. This is important because disputes usually increase during a recession! You may even want to follow up with a "customer service" phone call 10 days after an invoice has been mailed to encourage payment and to find out in advance if the customer will have any problems paying you.

Stretch out your payables as long as possible without incurring penalties. Try to negotiate terms with your vendors now to get at least 45- to 60-day (or even 90-day) terms. Create a financial reporting system that keeps track of cash more effectively, and manage it on a weekly basis. You’ll be surprised by the results of
getting tight with your receivables and pushing out payables - before too long you’ll probably have your two months of operating cash sitting in the bank.

Don’t make big investments. Now is not the time to pour lots of money into a big research and development project or to roll out a major marketing campaign. During a credit squeeze, you need to focus on your core products, fundamentals and competitive advantages. And don’t count on increases in sales to fuel any big spending projects. Remember that your customers will also be affected by a financial crisis, and will not be buying as much product as they were during the good times.

Turn more inventory. Your cash is wasted if it’s tied up in excess inventory. For example, a manufacturing company turning its inventory three times a year needs to buy four months worth of materials. Now that you’re paying closer attention to cash flow, you’ll be more sensitive to the fact that cash is now sitting
on the shelf generating no return for 120 days!

These are just a few things you can do to prepare for a credit squeeze, and even if the markets and lending trends change for the positive, taking these steps will strengthen your business. At any rate, if you start to feel the heat, don’t get suckered into thinking that someone has turned up the thermostat in your office. Rather, be aware of what’s going on and do something about it…or you, too, will become a delicacy on the frenzied financial market’s plate.


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