Business Cycle Preparation
Business Cycles
A business cycle is the economic fluctuation that happens over periods of time. A business cycle is said to have several stages, typically including a growth phase, followed by a decline, followed by a turnaround to growth.
Studies show business cycles tend to be about 4 to 5 years in length. This, however, feels a bit short when compared to major stock market movements, which tend to have about a 7 year cycle. The 1990s saw a relatively long cycle with a strong down turn in 2000 to 2002. September 11, 2001 caused much of the down turn, but it was not the only factor – the .com bubble bursting, the collapse of Enron and the Worldcom failures were also factors. 2007 began the financial crisis meltdown with 2008 gaining real traction and 2009 being the depth of the cycle. The point is that indeed between 2002 and 2007/2008 is about 5 years. Thus the message is that business cycles are indeed a regular part of business.
Are business cycles connected to a particular company?
Yes and no. No, in that the economy is the normal framework that causes business cycles. Yes, in that a business can have its own cycle independent of the economy. For example, a business that is related to a commodity can have commodity price cycles. As the price for the commodity goes up, more participants come into the market or the harvest is extra bountiful and the price falls, setting off a contraction. Similarly trades can have extra pricing causing companies to expand, which in turn can create excess capacity. Today the solar power manufacturing industry is going through such expansion creating capacity in excess of demand. A company can expand based on perceived market opportunities, but if the opportunities do not prove to exist, the excess capacity then causes the need for contraction. In technology, product life cycle is another version of business cycle. One moment the product is leading edge, then a new technology increased the available options or efficiency and the current product is out of date and contracting.
Regardless of the reason for or the stage of the business cycle, small business owners face the daily challenge of making decisions in the midst of this muddle. This resource addresses the need to understand business cycles and seasonality, the need for preparation for the down cycles, and the use of forecasting as a business discipline for ensuring sustainability.
Understanding Cycles
There are many types of cycles in business: start-up cycle, product life cycles, industry cycles, and sales cycles to name a few.
The Start-Up Cycle
The Giersch Group has called the Start-Up Cycle the S Curve™. This cycle hits virtually every startup business in this pattern: begin strong, grow by 15, 20, or even 30% for a period, then sales decline, sometimes by 60 to 80 percent. We attribute this to most business’ reliance on friends and family members of the owners and employees of the company boosting initial sales revenue. Below is an illustration of the S Curve™.
Many small business owners make the mistake of thinking that they are driving their company’s revenue stream. When businesses first start up, it is not uncommon for them to experience tremendous growth in the first year or two. Because revenue appears to be streaming in at a steady rate, business owners project continued upward growth and become anxious about capacity to meet this growth. Because of the higher revenue the owners begin to increase their overhead costs (notice the red dotted arrow on the chart above as it creeps up to intersect with the revenue line) and upgrade—new hardware, new office space, new equipment, etc. But suddenly, business owners discover that the friends-and-family market is maxed out, and there is no more growth in revenue. Instead, revenue falls off. The result is significant negative cash flow.
From a capital perspective, the company burned through the startup capital as planned during this “friends and family period.” The plan was to be over break-even, but now there is no capital to fund the continuing and often deepening losses. Many small businesses do not survive this -cycle. However, the implementation of systematic marketing and initial capital preservation along with conservative forecasting can minimize the effects of this cycle.
Product Life Cycles
A product life cycle generally is referred to as introduction, growth, maturity, and decline. Many new product lines or services that are launched within existing businesses go through a similar S Curve™. Again, the creation of a marketing plan with a monthly financial forecast can allow the business to anticipate and prepare for this cycle.
As outlined below for Industry Cycles, a business can develop a series of strategies to continue to expand the growth of the product by going to new markets or creating product extensions. Marketing can pay a key role in expanding the market for the product. One client was able to dramatically expand the market reach of a product that had been in existence for decades by aggressive media based marketing. Early efforts did have costs exceeding sales, but over time the marketing investment has paid off in high enough revenue to give expanded profits. Such a move for the smaller business is quite brave, and needs to be done in a way that one is not “betting the ranch.” In this case the company had stable profits and could model the marketing investment against revenue trends. At no time did the company’s income go negative.
Industry Cycles
An industry life cycle often comes in four phases: introduction, growth, maturity, and decline. Sales often begin slowly, experience rapid growth, level off as maturation occurs, then begin to decrease. Businesses often expand to new markets, increase product innovation, or expand geographically in order to prolong the growth phase. For example, Starbucks began a rapid international expansion when it had saturated the national market for coffee locations. It also began experimenting with additional product offerings, such as breakfast sandwiches, in order to maintain high growth rates to satisfy Wall Street analysts.
Fortunately, the private business owner does not face growth rate pressure from Wall Street. However, each business is still faced with an industry cycle. For example, the corporate lodging industry (fully equipped lodging alternative to hotels) experienced this cycle when it experienced a nearly 40 percent drop in housing units from 2000 to 2002. It then began to grow, dropped again with the 2007 recession, and then began to rebound in 2010. Cycles have caused corporate lodging businesses to get creative in managing flexible inventory as well as differentiating themselves by creating community or adding amenities.
Sales Cycles
Many businesses also experience seasonality in sales, whether it is the year-end holiday rush for retailers or the textbook purchasing for publishers and bookstores at the beginning of each semester. An evaluation of monthly sales and ending cash will allow a business to determine the seasonality and prepare accordingly.
Preparation for the Down Cycles
While no cycle or season can be controlled, systematic anticipation by the business owner can allow for preparation for the down cycle. Rarely is high growth sustainable, even if that part of the cycle seems to last for a long period of time. Part of preparation for the down cycle is the need to build reserves.
At this point it is hard not to cite the case of Pharaoh and Joseph, where Pharaoh had the advantage of being warned that there would be a cycle of 7 years of good followed by 7 years of drought. So a reserve was prepared which was sufficient to carry that nation through the 7 years of drought. Unfortunately, most of us do not have the benefit of being warned of a coming cycle. Therefore we need to run the business with the assumption that in the near term a down cycle may begin. This means keeping our companies strong and having reserves.
Much as inventory is built in preparation for the high-holiday season or in a time of growth, cash reserves should also be built during peaks in preparation for the troughs that are bound to come. Although it varies by industry, a minimal cash reserve for a small business should allow for covering at least three months of operating expenses.
Strong Financial Systems as the Warning Device
Good financial systems are the next best warning device of where the business is in the cycle. Monthly financial information, with budgets and with strategic plans set in the context of a financial model is recommended. The monthly financial information will give management a timely heads-up as to movements in the market. Comparison of a month to the prior year and the budget puts the current period in context. If the revenue is up year on year, then expansion is happening. If the revenue is below budget, then costs need to be aligned and the reason for the short fall rigorously explored. Budget short falls are warnings that expansion may be over. Costs must be aligned to actual results in a real time fashion, which financial statements allow.
Good strategic plans with forecasts of revenue, expenses, profit, and anticipated capital expenditures allow the owner to anticipate the cash needs of the business based on those assumptions. A good model should allow for several scenarios to be run, a base case that assumes all is well, an optimistic case that assumes significant increase in revenue, and a downside case that assumes significant decrease in revenue. Significant for this purpose would be 20 to 30%. Many companies experienced 40 to 50% declines in the 2009 period. With this output, the strategy should include action and action points to be taken if either the optimistic case or the downside case become reality. Such a drill is equivalent to the life boat drill on a cruise ship. Always remember the Titanic did not need these and was not prepared!
Such modeling allows a business owner to act with a level of certainty in decision making as actual results can be compared to forecast on a monthly basis and the model adjusted. This allows systematic preparation for seasonality and cycles.
Anticipating cash needs has two features: near-term and long-term. Small businesses should know whether they have enough cash to get through the year. This should be part of the annual budget cycle covered in November, updated quarterly, and current with the business year. Businesses must be able to anticipate and understand the seasonality of their industry so they can plan ahead. A successful company, through forecasting, must seek to match their cash inflow with their cash needs. Maintaining a Cash Flow Forecast is an essential way to gain understanding about the demands on your company’s cash. (The Giersch Group speaks to cash flow forecasting in more detail in our article Cash Flow Management.)
Actions
- Review the Strategic Plan, a September activity, for an optimistic and downside case.
- List the actions the business should take if either case appears to be reality.
- Review the cash requirements for the next year and compare that to the cash forecast.
Articles for Further Reading
- “Business Cycles.” http://www.inc.com/encyclopedia/business-cycles.html. This article further explores the four stages of a cycle and the major factors that contribute to a cycle.
- “Industry Life Cycles.” http://www.inc.com/encyclopedia/industry-life-cycle.html. This article walks through the stages of the industry life cycle.
