Survival tactics for a business slowdown; a financial contingency plan is valuable for coping with a sluggish economy's effects.

The official arbiter of recessions, the National Bureau of Economic Research, probably will not decide until sometime after the turn of the year whether the current decline qualifies as an official recession. In the meantime, evidence of a widespread business slowdown is accumulating rapidly. Even before the Mideast crisis pushed up oil prices to the $40 per barrel range, the long-lived business expansion that preceded it was showing signs of age.

Final demand (consumer, business and government spending and net exports) has been weak for more than a year. Consumer outlays for goods, capital spending, residential construction and defense purchases, which together account for 49% of the gross national product, are all below their September 1989 levels. Put another way, roughly half of the economy has been in recession for a year. Only a $27.3 billion surge in inventories prevented a recorded decline in real GNP in he second quarter of 1990. Since weak sales apparently were responsible for the inventory buildup, final demand could drop further as business moves to pare the unwanted goods. To the extent that rising oil prices lower consumer purchasing power and add another increment to business costs, they will assure a continued slump in demand.

REGIONAL RECESSION

The current business slowdown differs in one important respect from pasre recessions: Its impact varies from region to region. Indeed, depending on where one lives, the recession may be perceived as just arriving, being felt full force or going.

For example, the economy in the Pacific Northwest remains strong, fueled by a booming commercial aircraft industry and growing exports to Pacific rim countries. States with oil-driven economies, such as Louisiana and Texas, already have weathered a recession brought on by the plunge in oil prices four years ago. According to Jake Netterville, CPA, of Postlethwaite and Netterville, Baton Rouge, Louisiana, now they are in a recovery phase, and are "lean and mean and ready for anything." Curt Mingle, CPA, of Clifton, Gunderson & Company, Peoria, Illinois, says the farm and heavy machinery economy of the Midwest is also on the road to recovery from an earlier recession, thanks largely to rising exports.

On the less positive side, the Northeast is in the throes of a recession that began several years ago, with falling real estate values, rising unemployment and chronic state and local tax deficits. New York City and its environs have been particularly hard hit by the collapse of the junk bond market and its impact on te financial services industry. More recently, falling consumer demand began to affect production schedules at textile mills in the Middle Atlantic and Southeastern states.

DEVELOPING A FINANCIAL

CONTINGENCY PLAN

Whether the business downturn is just beginning to pinch or has taken hold, most companies will face a more difficult competitive environment in the months ahead. In such a climate, CPAs should make certain that individual clients and companies are in a position to respond quickly to evidence of a slump. To do this, management first must sharpen its ability to identify the effects of the business slowdown on the company's operations. Then, when a slow-down becomes apparent, management must be able to take timely corrective action. Together, these are the two elements of a financial contingency plan. Such plans are seldom easy to develop but they give management the information necessary to take prompt action that can soften the impact of a business slowdown.

IDENTIFYING CRITICAL FACTORS

The sooner management recognizes a slump exists or is imminent, the sooner it can take action to contain it. In looking for early warning signs, Netterville says it is important "to anticipate the ripple or domino effect" a major industry can have on a region's economy. He says the economy of Baton Rouge had little to do with the oil business. He adds, however, "We had customers who had customers who were in the oil business. So, as the impact spread, we found that, in a sense, we were all in the oil business." Netterville believes problems in a dominant regional industry often turn out to be early warning signs of an impending business slowdown in that region. Residents of metropolitan New York City, which is still reeling from the impact of the collapse of the junk bond market on the financial services industry, undoubtedly would agree. Most companies regard sales trends as the prime barometer of business conditions. However, sluggish sales are not among the most reliable indicators of an impending slowdown. Short-term sales patterns are too volatile to be used in forecasting and, by the time a trend becomes evident, it may be too late to take action. However, other parts of monthly financial statements can provide useful information.

* Assets. Sudden changes in certain assets are the most reliable indicators of a slowdown. A sudden build-up in inventories or a decline in the inventory turnover rate is always a cause for further investigation. It could be argued that the inventory bulge in the second-quarter 1990 GNP report signaled the beginning of an official recession. In any case, if information about both the level of inventories and the inventory turn-over rate is unfavorable, it usually means a company is in a slump.

A downturn in the accounts receivable turnover rate suggests customers are finding it difficult to pay bills and can signal the beginning of a decline. Cash balances, like sales, are too fluid to allow realistic conclusions but a slackening rate of cash inflow can indicate a problem.

* Liabilities. Warning signs include the sudden drying up of a primary source of financing, such as a loan request refusal by a bank, or an inability to convert short-term debt to longer-term obligations. A rapidly rising debt-to-equity ratio is always cause for concern but, when it is coupled with other early warning signals, it is particularly worrisome.

* Expenses. The inability to pass along increased costs to customers is the most valid sign of a slowdown in this category. It means demand is weakening or competition is getting stronger. Either way, a drop in sales is likely.

COPING WITH A SLOWDOWN

Once a slowdown becomes apparent, management should move as quickly as possible to contain it. The earlier the remedies are instituted, the more effective they will be. More important, if the early actions prove successful, it is less likely that more stringent measures, possibly affecting the longterm prospects for the company, will be needed down the road. Again, the remedies can be grouped into three categories.

TAKING ADVANTAGE OF ASSETS

Keep in mind that reducing current assets is the most common method of preparing a company for a slowdown. While it is possible to lower investments in fixed assets as well, their disposition may take some time and could affect the long-term potential of the company.

* Inventories. Three small firm practioners--Carl P. Gross of Altschuler, Melvoin and Glasser, Chicago, Illinois; Charles B. Larson, from Saint Joseph, Missouri; and Mingle--agree that reducing inventories is a painless and appropriate way to cope with a business downturn. Gross says reduced inventory levels also free up credit lines, which can be used for other purposes.

The most common method of measuring inventories, the inventory turnover rate, is useful in controlling the physical level of goods, but ignores a company's inventory investment. A CPA controller for a mid-sized retail operation developed a system that divides inventories into paid and unpaid portions, thereby allowing management to keep investment to a minimum. The first step is to obtain inventory balances for the beginning and the end of the month. Next, look at the inventory accounts payable balances for the beginning and end of the month. Each of these balances represents the unpaid portion of total inventories at a specific time. It can be assumed that the rest of inventories on hand have been paid for.

This information can be interesting. For example, suppose a company starts the month with $1,200,000 in inventory and an inventory accounts payable balance of $500,000, indicating inventories of &700,000 that have been paid for. By the end of the month, inventories drop to $1,100,000 but accounts payable fall to $400,000; this means the company's investment in inventories remains at $700,000. Thus, the company's finances derived no benefit from the $100,000 drop in inventories. In a slump, the failure to reduce a company's investment in inventories can lead to trouble.

* Accounts receivable. Another method of coping with a recession is to tighten up on customer credit. This means companies should try to determine whether customers have the resources to survive the slump. As Netterville puts it, "Just because they've been good for years, it doesn't follow that they will be around forever." Gross also recommends that companies take a look at the contribution customers make to the bottom line. He says, "If a customer has been an administrative nightmare involving all sorts of internal costs, maybe it's time to cut loose."

However, the biggest concern in administering accounts receivable is the effectiveness of the collection operation. The two most pupolar yardsticks for measuring credit activity give valuable insights but also have sever limitations. Days sales outstanding (DSO) measures the cost of carrying receivables but says nothing about the amount of money coming into the company. The ratio of bad debts to sales measures credit mistakes but tells nothing about aging receivables that have not yet reached the bad debt stage.

A measurement that calculates the speed of a collections effort appears to overcome these drawbacks. First, the age (in days) and the amount of each paid invoice are gathered. Then the value of each invoice is multiplied by its age. At the end of the month, the total flow of funds from invoices collected is divided by the dollares received, to obtain the average collections speed for the period.

Here's how the calculation might look for a small company. In the example, it took the company an average 29.64 days to collect $1.00 in receivables. Thus, the company is doing well if it set a 30-day collection rate as its target.

[TABULAR DATA OMITTED]

* Fixed assets. There are two drawbacks to disposing of fixed assets during a business downturn. First, prices are likely to be under the optimum level, as realty prices in the Northeast will attest. Moreover, assuming the assets were acquired for a purpose, selling them in a recession could inhibit recovery or growth when the economy turns up again.

Capital spending plans should be reviewed carefully. Expansion projects probably should be deferred until evidence of a recovery becomes clear. Although it still may be prudent to move ahead with programs to replace equipment and improve efficiency, even these projects should be reevaluated if they required using working capital or taking on additional debt.

MANAGING LIABILITIES

When sales turn down, reducing the flow of cash into a business, effective liability management is often the key to a company's survival.

Loans and debts should be kept to a minimum in a business downturn. This is particularly true when interest rates remain at relatively high levels, resulting in high fixed financing costs on outstanding debt. When financing is required, a line of credit giving the company the flexibility to deal with the consequences of the recession as they occur is usually best.

In a slump, it is always wise to keep cash as long as possible. Companies should avoid paying bills early. If extended payment terms can be arranged with some suppliers, it is prudent to take advantage of them. But companies should not stretch out payables too long. Such a tactic could help short-term cash flow, but will only aggravate the situation as past-due bills pile up late on. In a protracted slump, consistent late payments could damage credit relationships.

PARING EXPENSES

Cost reduction is essential in a business downturn. The first area to look at is overhead; most companies find room for reductions in this area because excess spending invariably creeps in during good times. As examples, travel expenses can usually be reduced, an insurance review could identify unnecessary coverage or deductibles that could be raised, internal reports or forms might be eliminated or a change to more powerful data processing hardware or software might be deferred.

Personnel reductions should be put off as long as possible. If the slowdown is relatively short, retraining costs could more than wipe out the savings in labor costs. Moreover, layoffs have a negative impact on employee morale.

LOOK FOR OPPORTUNITIES

Larson says a downturn can bring business opportunities for companies that look for them. Indeed, when competitors are pulling in their horns, it could well present a golden opportunity for an aggressive, well-situated company to seek new markets. Larson speaks of a situation during the last slump in automobile sales. He told a group of automobile dealers that there were two ways to counter the effect of the slump. They could either put more emphasis on service and mechanics or seek greater market penetration. Since the competition was caught unaware, those who sought to broaden their markets generally were successful.

In short, while CPAs should keep clients and companies fully apprised of the changing business conditions that may lie ahead, they also should note that a business downturn does not rule out opportunities for companies prepared to operated in such a climate.

GENE R. BARRETT is a news editor of the Journal.

Mr. Barrett is an employee of the American Institute of CPAs. His views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.