How to be prepared for crisis
The COVID 19 pandemic has been described as a once in a life time event. However major economic shocks occur more frequently than that. What is clear is that crises and market turbulence are inevitable and periodic. It's not a question of if but when. So, how can businesses stay prepared for crises?
Many businesses have adapted during the COVID 19 pandemic and developed new, more efficient practices while working from home. New industries have emerged and decentralized decision-making has led to improved operational performance at times. This means that planning and preparing for the next "once in a lifetime crisis" or the next "once in a century flood" is not a waste of time, money and effort. Instead, such planning should become part of every company's strategic and financial toolkit.
We analyzed the balance sheets of the best performing companies to see what the magic formula is to weather the biggest storms of economic crisis.
Managing cash for crisis
According to corporate finance theory, a company holding a dollar of truly excess cash should return it to its shareholders so that they can reinvest it. Cash is used to the fund operations of a company, or make acquisitions or provide liquidity in uncertain times. However cash on the balance sheet is viewed as an unproductive asset (with only interest showing up on the profit line.) Given what we know about unexpected shocks perhaps companies should hold more cash in anticipation of another crisis to act a liquidity buffer and mange cash through the cycle. Some companies will be more vulnerable to value destruction than others, and understanding how that impacts the business should become an integral part of liquidity planning.
How leveraged should your company be to best deal with a crisis?
After establishing the importance of understanding liquidity needs through cash balances and cash flow volatility, it is also important to consider leverage in the broader picture of a well-capitalized balance sheet.
Exhibit 5 shows the long-term total shareholder returns for companies with high leverage and companies with low leverage in the S&P 1500. The chart shows some benefit to having lower leverage during crisis events. Plus, there seems to be a secular trend of general investor preference towards lower leverage even in benign markets.
Expect crisis – climate change could be the next big hit
Within any economic cycle, events are bound to take place that will demand a recalibration of your own plans. Companies should start to expect crises, and even to integrate them into your strategies for how you run your businesses. The market seems to increasingly favor those companies that can weather the next storm. Although we may not know when – or from where – the next shock will emerge, we must be aware of a variety of possible threats. For example, we have only relatively recently begun to experience the environmental and economic impacts caused by climate change. But recognizing that threat – and others – are out there is the first critical step in ensuring that we don't experience another episode of selective memory or failure of imagination. Consider that – while either weathering a storm or enjoying a bright and sunny day.