Due to the COVID-19 pandemic, businesses are grappling with a high degree of uncertainty and some fear about their revenue, profit, and cash flow for the next several months or longer. Due to the large number of clients seeking our help with financial contingency planning, we want to share an approach that has been quite effective for us. We hope this is helpful for other accountants supporting their clients.
This article focuses on modeling and managing through potentially large sales declines until economic activity recovers to a normal level. First we’ll focus on underlying operating profitability, then look at cash flow management.
P&L Scenario Analysis
1. Assess Sales Scenarios
First, work with clients to assess revenue streams overall and the risk they decline. Also assess individual customers and the risk they curtail purchases. Forecast a few realistic scenarios ranging from what would be a modest decline for your client to what would be a large decline. These forecasts will vary significantly by industry and by companies within the same industry. You might end up with the following scenarios:
2. Assess Direct Cost Structure
Second, assess the variable and fixed direct costs of producing and delivering goods and services. Note that while on paper variable costs cut themselves, in reality you need to make sure your client for example does not reorder supplies which are not needed. Project those variable and fixed costs over the revenue forecast scenarios. You might end up with the following direct cost and margin scenarios:
3. Assess SG&A Cost Structure
Third, look at your client’s Marketing & Sales and General & Administrative expenses, and separate the fixed from the variable costs. Project those variable and fixed costs over the revenue forecast scenarios. You may end up with the following SG&A cost scenarios:
4. Compile Full P&L Scenarios
Fourth, compile all this data into a set of full P&L scenarios to review with your client. This will paint the picture of their profitability at varying levels of sales decline. There will be a point at which your client becomes unprofitable, in this case around a 17%-18% sales decline.
5. Plan and Prioritize Cost Cuts
Depending on how dire your client’s forecast scenarios are, they may or may not need to enact cost cuts right away. Even if they have a healthy cash reserve and do not expect much of a decline in sales, it is worth spending some time helping them create a contingency plan in case sales decline more than they expect.
Because variable costs naturally drop when sales drop, cost cutting efforts focus mostly on reducing fixed costs. Certainly clients should chisel away at variable costs the best they can. However, if their business shrinks significantly in size it is inevitable that fixed costs will be too high as a percentage of revenue.
The largest fixed cost in most businesses is payroll. Eliminating salaries is a painful decision and you may be able to bring alternative ideas to your clients, such as temporarily moving certain positions to part-time or an across-the-board salary reduction or a furlough.
How aggressively clients should cut costs is largely a function of:
- How profitable the business is currently, and how far sales need to decline in order to lose money
- How much cash reserve the business has
- How confident the business is in its sales forecasts and resulting P&L forecasts
- How much tolerance ownership has for losing money, including its ability to forego pay for some period of time
Cash Flow Management
Once you have modeled your underlying P&L for clients, then you can model expected operating cash flow from those scenarios.
You may need to help clients understand the dynamic that when sales are contracting, cash flow can be positive as accounts receivable are being collected at a faster rate than new sales are being invoiced. This cash influx is a one-time event. Once older outstanding receivables are collected, then they’re left collecting on a smaller volume of more recent receivables. However, this positive cash flow only results if cash expenses are less than cash receipts. So make sure clients make those cost cutting moves driven from your scenarios even if it looks like cash is rolling in.
Cash Flow Vigilance
In dire economic times, cash flow vigilance is more important than ever. Here are a few basic cash flow practices to encourage:
- Identify how much clients have on hand relative to monthly operating expenses. There is a level at which they can’t go below and still be able to make payroll. That may be around ½ of one month’s operating expenses. If they approach that level, rapid cost cutting and/or borrowing is critical. They may need to monitor this daily, at a minimum twice per week.
- Be extra diligent on collecting accounts receivable and identifying bad debt risk before those customers get into clients for too much, especially if clients incur third party cost of goods sold that they must pay out even if their customers do not pay them. In the midst of a pandemic, clients must assume any customer could be in financial distress and unable or unwilling to pay them. Naturally clients want to be accommodating to good customers, but they also need to protect their own business.
- Negotiate extended payment terms with their largest creditors. If they can get an extra 15 or 30 days to pay a large vendor, that provides an extra 15-30 days to collect from customers.
- Conserve cash and approve only essential expenses.
Nurture or Establish Bank Lending Relationships
As the old saying goes, the best time to borrow money is when you don’t need it. While it might be a little bit late for that now, it is the time for clients to review their borrowing capacity in the event they need or want to borrow money.
If they don’t have a line of credit, now is the time to put one in place. If they already have one, they should speak with their bank about increasing borrowing capacity. If they have drawn down a large amount on a line of credit and don’t expect to repay it anytime soon, they should consider trying to convert it into a term loan with a fixed interest rate for a number of years not subject to annual renewal.
Encourage clients in need of capital to pay close attention to special programs the U.S. Small Business Association (SBA) is ramping up, with new information being released frequently on the SBA website.
Understand Cost of Capital Sources
There are various sources of capital small businesses can draw upon. Small businesses tend not to understand the cost of various sources of capital. It’s helpful to point out the 4 general types of sources:
- Owners contributing more capital or foregoing wages. This is nominally free, though there is an opportunity cost to ownership of investing more capital in the business.
- Bank line of credit or term loan including SBA-backed term loans. Interest rates are in the mid-single digits, though personal guarantees are required and sometimes liens on owners’ homes.
- Mezzanine lenders beyond traditional banks. Credit cards and factoring fall into this category, as do other non-bank lenders who are comfortable lending in higher risk situations with less collateral or security in exchange for higher interest rates in the 20% range.
- Online lenders such as Fundbox, Kabbage, and now QuickBooks Capital which connect to QuickBooks and use QB data, primarily accounts receivable data, to very quickly underwrite and advance loans. Interest rates range from 24% to 40% or more, so these should be a last resort.
Author Bio: Calvin Wilder is founder of SmartBooks Genie, an application powering client accounting services practices. Integrated with QuickBooks, Genie automates accrual accounting, monthly close management, custom reporting and dashboards, task management, and scope of service-based pricing. Cal also founded SmartBooks Services, an early cloud-based client accounting services firm, where he continues to enjoy advising clients in a CFO capacity.
This story reflects the opinions and/or recommendations of the contributing author, it does not necessarily represent the views, opinions or formal recommendations of Insightful Accountant.