COVID-19: How to make strategic decisions
Lockdowns and stay-at-home orders to corral the coronavirus pandemic are challenging businesses, particularly small and midsize enterprises, worldwide. Many have watched revenue decline drastically, some up to 100%, and profits turn into losses. At worst, the pandemic’s economic impact poses an existential threat.
Management teams are responding to this crisis in different ways. One primary focus is to minimise losses, more specifically, to minimise cash losses.
They can cut costs, identify savings by improving efficiencies, and reduce the pace of declining sales by identifying alternative products the companies could generate using their assets.
In the apparel industry, for example, potential options to bring down fixed costs include renegotiating rent paid for factories and reducing labour costs. Potential options to reduce variable costs include negotiating with suppliers, and the decline in sales may be arrested by switching production to personal protective equipment (PPE), using the now abundant spare capacities.
These quick responses are important, but it is equally important that companies look beyond the short term and think about the medium and long term. Depending on the relative impact of the pandemic on a business, it is important that management devises a strategy on how to respond to a recovery that may be slow and gradual.
Projecting cash flow
Survival and recovery depend on generating cash, and any cash flow projections depend on how long the crisis will last and how long lockdowns and recovery will take. Let’s assume a medical solution for the virus will be in effect within 12 months and health concerns are successfully addressed by medical research.
Using the timeframe reference, a business should make best estimates of the amount of cash it would lose over the coming 12 months. These estimates should be continually updated and monitored based on the evolving situation.
Based on the best efforts of management, the business should project the timing and extent of any negative cash and figure the cumulative cash loss likely over the next 12 months. Various assumptions regarding sales recovery and costs need to be made in order to arrive at this estimate. Further, the cash forecast should factor in the timing differences of profits and cash flows due to working capital movements.
Management may carry out cash forecasts under multiple scenarios to understand the potential range of outcomes and assess the broader potential range of the company’s cash position. With time, management will be able to conclude which scenario is most likely for the business.
4 strategic options
A company’s cash burn (negative cash flow relative to the available cash reserves) is “high” when the cumulative cash losses at the time of the peak cash loss exceed cash reserves the company can access. Cash reserves for this purpose include current cash reserves and future cash reserves such as new loans and government grants. Cash generated from operations is already factored in to determine monthly cash burn.
The coronavirus pandemic will undoubtedly have some lasting impact on certain industries and consumer behaviour. This may be due to continued social distancing, changed purchasing patterns, or changes in the disposable income of consumers. Therefore, businesses must make a judgement call on the recovery time following lockdowns and shutdowns.
For example, utilities could be expected to recover fast, but travel and leisure industries may take longer. Depending on the expected speed, recovery time is classified as “long” or “short”.
The following action grid, or COID model, is based on the combination of cash burn and recovery time.
Each action represents a strategy that is based on projections. The four actions of the COID model are:
Conserve. The business is expected to recover fast, probably because it generates an essential product or service such as food or pharmaceuticals. The company has access to adequate cash reserves in the foreseeable future. Management is fairly confident a recovery will be fast.
The company should take measures to conserve its cash so that liquidity is preserved and the business can be responsive to post-pandemic opportunities such as acquisition of weaker players in the industry or new investment opportunities.
Off. The pandemic’s economic impact on the company will linger, and recovery is expected to take a long time. Continuing operations will result in large cash losses. Examples may be airlines and restaurants. The suggested strategy is to temporarily shut down the business to reduce losses.
This strategy relies on fixed costs potentially becoming variable over time. The company could renegotiate fixed obligations or cancel some, such as lease agreements, potentially incurring penalties. This would preserve cash in the long run and enable the company to bounce back with minimal damage.
It may be necessary to source cash inflows from the government or other stakeholders and to defer or eliminate cash commitments.
Innovate. A company is burning through cash quickly but hopeful of a quick recovery once lockdowns and shutdowns are eased. Meanwhile, it is important to take innovative measures to reduce cash burn and identify new revenue opportunities. Examples include a retail store shifting to home deliveries, an apparel company pivoting to manufacturing PPEs, or a distillery producing alcohol for hand sanitiser.
Swift action extends the hope for these businesses and could reduce the severity of the cash burn until the time of recovery.
Dilute/divest. Cash burn is not significant, but the business may not return to pre-pandemic levels soon. This could be due to a change in consumer behaviour or lasting economic impacts. A luxury goods company or a travel business could be examples.
It’s important for these businesses to obtain long-term cash support. Diluting a stake or divesting a part of the business to a stronger acquirer could be prudent strategies.
Modelling future cash flows to customise survival strategies can help a company recover and revive once the coronavirus pandemic is under control. The model could also be applied to nonpandemic situations arising from large shocks to economies such as natural disasters, terrorist attacks, wars, recessions, or any black swan event that creates major dislocations in the market.
When industries are disrupted and survival is challenged, the model may provide a long-term strategy to deal with an uncertain environment.
For more news and reporting on the coronavirus and how management accountants can handle challenges related to the pandemic, visit FM’s coronavirus resources page.
— Senaka Kakiriwaragodage, FCMA, CGMA, CFA, is the managing director of NDB Zephyr Partners Lanka, the management company of Emerald Sri Lanka Fund I Limited, a private-equity fund dedicated to fund fast-growing small and midsize enterprises in Sri Lanka. To comment on this article, contact Sabine Vollmer, an FM magazine senior editor, at Sabine.Vollmer@aicpa-cima.com.