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Managing Financial Distress Post Attenuated COVID-19
While keeping the approach simple, much cleaning may be needed to make that happen. Top management needs a lot of energy and stamina to carry through addressing the tense issues, especially relating to career, appraisal, employee compensation and benefits
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Economic uncertainty created by coronavirus risk has given rise to considerable strategic thinking and change. Cost configuration of companies play a pivotal role in management thinking to support strategic changes, restructuring, and reconfiguration of businesses in meeting the emerging challenge emanating from the pandemic.
Coronavirus pandemic has disrupted our activities. Operations have to come to stand-still. Some of the work has shifted to work-from-home. For everyone, these are unprecedented times, and corporate leadership is going to tested to confront the real VUCAF (volatile, uncertain, complex, ambiguous, and filled with fear) world situation that is unfolding as we read this article. All trade-offs management used to play around needs to be reset. Several trade-offs in life have disappeared. For example, there is no trade-off between convenience and precaution. The attenuated post-corona world is going to test the financial acumen of executives managing operations of their companies. Uncertainty around future cash flows is going to create financial distress situations forcing companies to make many hard decisions.
There would be very few options.
How should executives play out this phase? First, an adage "cash is king" is going to be prominent thought and force the companies to change their strategies and work out arrangements that help them sail through these difficult times. All companies are going to go through this extraordinary situation, but consequences may vary. Companies facing brunt on revenues and experiencing a change in their revenue cycle may face the challenge of not being able to support the existing cost structures. Companies will explore using their reserves to meet the obligations to avoid being like in or near-insolvency situation.
The fundamental accounting inequality of revenues > expenditures will be under serious threat for many businesses. It needs to be reset. Exploring options to change the dynamics on both sides is inevitable. Options to increase revenue, or borrow more money or use reserves (e.g., unused limits) generally considered as a first resort in pecking order may not be available. Any borrowing in an already high leverage situation may be undesirable and not available. As one of bankers mentioned that your bank sanction letter does not matter, only the amount in your account does. All valuation and assumptions are going to be different in the future. There is no option than to look at the cost side of the business in detail and take vigorous actions to modulate the costs.
In this journey, CFOs and top management need to remember that they are not alone in this journey. Coronavirus pandemic is a systematic risk and everyone is impacted. This is big in magnitude, severe, and has broader implications. This needs much attention, and serious thinking as the human side of the strategies is going to play a pivotal role. We are all linked in the market, and any action at our end is going to affect all stakeholders in varying degrees. The strategies available in normal market circumstances, such as reducing prices to increase revenue, may not work. We are in a systematic risk situation where everybody is affected. The power to carry through the strategies may have a limited impact.
Creating an environment
There is an adage that most costs get committed in good time and difficult to modulate in troubled times. Inefficiencies grow in a comfortable time when there is justification for everything. But in difficult times, companies need to make sure to examine the issues from zero-base and have a fresh look at the costs and expenditures. Prepare the organization to shed this inertia to examine the costs from zero-base. As there is a threat to future survival, this preparation is required. The organization will need a lot of support and coordination from everyone for preparing the change, and creating the environment is critical. As part of the preparation, leadership needs to articulate the problem and seriousness of the crisis and to create a sense of urgency around it.
Data analysis may help in communicating the urgency. Companies use several approaches to create a sense of urgency. Developing detailed benchmarks and future forecasts and risk scenarios and sharing the same may help under COVID 19 driven financial distress. Creating symbols in these times help. Many CEOs announce a reduction in their salaries or top management, deciding to cut their perquisites. This has a lot of symbolic value, and communication is effective, making it credible that senior management is willing to share the pain and participate in changing the cost structure. This is also the time to address the cultural issue of asking people to spend the money as if it is their own money. There are a lot of discretionary expenditures, and they need to examined and possibly eliminated without impacting their ability to sustain.
Helping everyone to develop financial acumen
Many of the employees may have some broad idea of the impact and first-hand experience of coronavirus pandemic but may not be fully aware of the financial situation of your company. The finance department is generally in the know of the liquidity issues and reserves available, but most of your employees generally remain unattended to the financials of the company. In normal times it has been observed that the financial literacy acumen quotient of people working in the organization is on the lower side. Any step to rationalize the cost or taking hard steps and develop a frugal attitude needs financial acumen. It is crucial first to create an environment by focusing on improving the financial literacy quotient of your organization. The top management has to initiate steps to improve the financial literacy of employees so that your efforts are communicated well, understood well, and implemented well. If we do not prepare the organization, your efforts may put you in a precarious position, and the management may not be seen as having a human face. It is necessary for all employees to understand the implications in a logical manner.
Linked cash flows
In organizations, costs are linked. They do not occur in a vacuum. Salary cost gives rise to the cost of space and utilities, and they are, at times, highly correlated. Selling does not always increase cash flows. Profit increase does not mean it leads to an increase in cash flows. Understanding such linkages helps in placing strategy of cash flow and cost optimization in place. However, cost optimization remains a complex exercise. This is because if one reduces one item, though, correlated may not respond in the same direction because of the stickiness of the costs. But at the same time, some costs are variable in nature that does not go down automatically unless there is a great deal of coordination amount the departments such as purchasing, production, marketing, and finance. For example, the reduction in production may reduce raw material consumption, but if the purchasing department does not fine-tune procurement, costs escalate. To create urgency and make communication effective, ideas presented in Box 1 may be useful to develop a thought process and sensitizing the people across the organization.
Deep dive into cost structure and find what is adding value
We must create COVID proof cost structures. The cost structures must be able to absorb the shock and come out making everyone better. Stronger cost structure are dominantly having costs what management can easily modulate, dupute resources without much resistance in uses which are sustainable, in nutshell whether company has resilient cost structure. This entails asking questions. Question each cost, which is not producing measurable outputs.
Question each cost, which is not adding value. Question what resources are required to achieve the goals. How does one do it? Activity-based costing is a tool to get insights into these aspects. (see Box 1). Each company needs to introspect the value a resource (human resources, technology, etc.) creates in the future (as compared to historical performance) and the commitment the company needs to make to strengthen the future. All restructuring decisions such as closing locations, closing stores need to be based on micro-cash generation analysis. From the economic logic viewpoint, there is no scope to cross-subsidize the deficit cash-generating segments of the business. A wide range of skills and creating positive power of value creation need to be inculcated, and this is a cultural shift. The commitment dimension is always challenging to determine. In difficult times it is not unusual for management to have less commitment as all of us are less sure about the future. A large number of companies will be invoking the clause of force majeure and adjust their obligations. This is likely to have a ripple effect on the economy. We need mutual support to overcome the tide. In summary, it is not enough to tweak the existing business models, but to rethink, rebuild, and reconnect.
The leadership role is paramount in situations of financial distress. Strategic reorientation, guidance, reassurance, creating a sense of urgency, prioritization of resource use, reducing the burn rates, speedy decision making is critical. In the emerging situation many of the old business will not be relevant and new opportunities would emerge. Top management will have to frequently review the portfolio of businesses and value propositions in each of them. Capturing the new opportunities would be critical to engage surplus employees that organizations might have built in good times. The communication explaining the situation assumes considerable significance, without affecting the morale. The credibility of your plans helps in creating greater trust required in distress situations. Decision making has to be fast.
While keeping the approach simple, much cleaning may be needed to make that happen. Top management needs a lot of energy and stamina to carry through addressing the tense issues, especially relating to career, appraisal, employee compensation and benefits. Delegated decision making needs a reset as all are going to look for guidance in making decisions, and therefore demands on leadership time is going to be high. Experimentation and risk-taking need to become the norm, and this trait will be tested. Tolerance to accept failure should be part of the new culture. In normal times organizations try to play safe. The leadership role has to make experimentation and risk-taking as a norm. Leaders have to demonstrate their problem-solving skills to build trust. Celebrate and share each small successes and take the blame for adverse outcomes to boost morale.
Box 1: Some Examples to Handle Financial Distress Situations
#1: Create Business Mutuals to Face Financial Distress Situation Collectively A company aims at reducing the cost of its procurements. The company decided to join mutual of a similar organization, for example, if twenty companies join to increase bargaining power in procurements. This may help in stabilizing the costs.
#2: To Cut Costs, Tighten Control of Discretionary
A manufacturing company aims to focus on optimizing its discretionary costs. These are the costs, such as advertising, research, and training, that may be discretionary in nature. Executives may decide to increase or decrease such costs, and they may not see any relationship with the activity levels. The company can start focusing on these activities and look at them from zero-base, which implies responsibility is placed on each manager to develop the budget from scratch after exploring all options and applying principles of management by objectives. Ask questions what are we trying to do, and what are the options of doing it in the environment we anticipate? The discretionary expenditures on salary and perquisites may reduce employee morale if modulated. Companies can think of consolidating and developing opportunities for cost-sharing.
#3: Turn Heads of Overheads using ABC
A company predominantly has overhead (all indirect costs) cost structure. The current cost drivers are based on traditional pre-determined overhead rates. The adage activity causes the cost gets violated in this system. Therefore the company wants to identify the cost based on activities done so that they can get a better idea of costs and can identify activities that do not add value. Activity-Based Costing (ABC) vs. Traditional Costing differences are as follows:
• Identify focus on key activities rather on cost/profit centres
• Collect Costs for activities than cost/profit centres
• Define drivers to allocate cost to each activity, then use cost allocation rate for cost/profit centre
• Charge all indirect costs to activity using cost driver instead using some predefined allocation rate
#4: How do I know activities are adding value
A company wants to know whether operations and activities performed by them add value. Value chain analysis is a technique that helps the company to understand whether separate operations are adding value to the product or service. The technique focuses on the operations activities and the processes by which the value gets added. The value chain analysis does an in-depth analysis of processes and the way the value gets added. The focus of the analysis is understanding the entire chain of operations and their contribution.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.