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Survival guide

By Yan Barcelo
Illustration: Jason Schneider

Some economists fear things will get worse. To guide clients through the tough times CAs are advised to stick to the fundamentals

Doom. Gloom. Slowdowns and recessions.
Then there is the financial tsunami that is destroying markets worldwide, while the Canadian dollar dropped by more than 25%in three months last fall and a barrel of crude oil dropped by 50% in less than two. These are indeed portentous times.

“What we see in the economy today will be in history books in 50 years,” says Robert Guerriero, a chartered accountant who manages finance and administration for Pelican International, a 300-employee manufacturer of kayaks and pedal boats in Laval, Que.

It seems likely that tomorrow’s history books will have to devote a few chapters to our present predicament. Of course, it is entirely possible that the waters will remain quite still and the Canadian economy could simply skate over a recession without falling into it. But things could also get worse, much worse, as many economists fear.

“I think demand is shrinking rapidly,” says John McKenna, partner and senior vice-president of the corporate advisory and restructuring group at PricewaterhouseCoopers in Toronto. There is a similar shrinking demand for Pelican products at large retailers such as Wal-Mart, Costco, Canadian Tire and others in Canada and the US. “Clients are more reluctant to place purchase orders and we [don’t really know] when they will renew them,” says Guerriero.

The banks are getting more finicky about loans. “If we want new money, it could be a difficult challenge,” says Oren Nutik, president of MDS Power Inc.,a Montreal-based distributor of conversion equipment that has offices in Canada and the US and deals with a bank on each side of the border. “[The banks] are nervous and they’ve been checking all our financial ratios and loan covenants. They even asked to visit our US locations.”

“The mentality of banks has changed dramatically in the past six months,” says McKenna, “and they are all currently very conservative in their dealings with both existing and new customers.”

It seems that the economic landscape will increasingly change, so prudence should be the watchword. As McKenna predicts, input prices will oscillate, the dollar will gyrate with changes in raw material prices, banks will be miserly and competitors will be hungrier.

So, what can CAs do for their companies or clients to help them navigate increasingly uncharted waters? Harvey Zalcman, partner at RSM Richter Chamberland LLP in Montreal, believes accountants should stick to fundamentals because people get into trouble when they forget them. That means keeping a sharp focus on cash flow, receivables and payables, expenses and so on.

But sometimes, fundamentals are not quite enough. Here’s an overview of what a CA should keep in mind if and when things get worse economically.

Attitude and altitude
In many peoples’ minds, fundamentals refer only to the technical stuff: numbers, ratios, the bottom line. But these are end results. At the outset, a business is about people, passion, expectations and attitudes.

Today, CAs should bring a new mindset to their clients by being proactive realists, says McKenna. They should not be blind to potential opportunities, but should also recognize that the market and economy have changed for the worse. Companies must consider what impact these changes will have on their businesses.

This can be particularly difficult in certain settings, especially in companies where managers mistake their wishes for reality. “I’m amazed at the number of companies that just muddle along, hoping to sell their way out of their problems,” says McKenna. “I call it the ostrich mentality. People see their problems, but won’t deal with them until it’s too late.” The proactive-realist accountant will make it a point to bring up problems on a timely basis and suggest concrete ways to solve them.

Of course, there are corporate cultures that simply do not allow anyone to rock the boat or blow any whistles. Business assumptions and expectations may be deeply ingrained and sensitive egos higher up on the corporate ladder do not want to be challenged. If things have settled this way, then it is probably too late. The CA has already renounced his or her central role of asking unpleasant questions such as, “Is it time to proceed with such an investment? Can sales projections be as rosy as you say?” However, the coming slump, if it deepens and brings a lot of anxiety, could be a good time for CAs to reassert their authority and enhance their value to the organization, McKenna says.

He believes accountants’ proactive realism must not stop at the general ledger. “They should ensure that their clients look after their personal affairs as well as the business, especially if they are entrepreneurs, and not let their judgment be clouded by the sweat equity they have in their company.” McKenna has witnessed situations where an entrepreneur pledged his or her personal assets to cover corporate debt in his or her sinking company or didn’t pay sales or payroll taxes to Canada Revenue Agency (which can create personal liability issues for the officers and directors) and used the money to buy inventory. If rough times do materialize in the future, such situations will inevitably pop up.

“This is a point where the chartered accountant can be objective and make an independent assessment of the business opportunities and then be honest with his or her client,” McKenna says. “In certain situations, the best advice might be: ‘close the company in an organized manner, Bob — don’t put your personal assets at risk just to buy a bit more time.’ ”

Flight plan
Numbers count, but not as much as the company’s strategic plan. Five years ago, your company thought it was flying high to El Dorado, but meanwhile the Earth has shifted and now you may be flying to bankruptcy. This is the time to question the business plan, even the business model. And this is where a CFO can play a major role, says Grant Robinson, partner at Robinson and Co. in Guelph, Ont. “He or she can make financial models to help management visualize where the business can move to.”

“The CA should encourage a client to revisit a high-level strategy,” McKenna adds, “and formulate a plan based on these new realities.” This revisiting can happen at a simple level where tough questions are required: can we expect demand to remain firm? What will sell at this moment? Should we liquidate slow-moving inventory to generate cash?

But the revisiting should also happen at a more strategic level, McKenna says. What are the company’s strategic advantages, what truly drives your profitability? He recalls the recent example of an Ontario company that designed and manufactured parts and got into financial difficulty due to customer pricing pressures. With the help of his CFO, the president performed a competitive advantage analysis and came to the conclusion that the design team was where the added value resided and was the reason why customers came back. However, there were only 30 people on the design team and 370 people in manufacturing. Still, the president tackled the problem head-on: he closed the three manufacturing plants, outsourced production and, as a result, successfully returned the company to profitability.

One might ask if this is the time to make such a radical move. “By all means,” says McKenna. “Such a plan is more important now than ever. Unless you’re in a survival or crisis mode, now is the time to do it. The accountant is the one who should ask what opportunities the company needs to capitalize on. For example, if a competitor fails, what do you do? Buy its equipment? Buy its intellectual property? Buy its clients?”

Your flight plan should prepare you to seize such important opportunities.

Information feed
“In difficult economic times, information is a question of life and death,” says Sylvain Vincent, managing partner for Eastern Canada at Ernst & Young in Montreal. “The accountant has to find the way to deliver information, even if it is not complete. But it must show what’s happening in critical areas: sale slumps, delinquent accounts receivable, stock level alerts, profit margin dips, expenses that have to be reduced, etc.”

Of course, upholding such a regime can be very demanding and the IT department may not be able to follow. “That means the management team must sit down with the IT people to solve the problem and find temporary solutions. It could mean displacing employees from routine tasks to ensure that the relevant information is accessible to decision-makers.”

In many cases, companies don’t even have access to accurate information, let alone timely information, says McKenna. “Often, when companies run into trouble, it’s just because they have rotten information. The accountant can help identify what key information is relevant and help tidy it up.”

Cash is king
It is important to get your company to focus on liquidity because cash is king right now, McKenna says. Cash-flow forecasting is therefore of the essence — forecast at least six weeks ahead, ideally 13. Why is this important? “Many companies are still profitable, but their liquidity is slowly being eroded,” McKenna says. “Look at Lehman Brothers, Wachovia and the other Wall Street giants: their immediate downfall was caused by a lack of liquidity. If you have a liquidity problem, the earlier you can see it coming, the better. You don’t want to come in on Wednesday and learn that you can’t pay your workers on Friday.”

Unfortunately, many companies only forecast cash flows on a weekly basis and don’t forecast out beyond that. “You’d be surprised at how poor cash-flow forecasting can be in companies,” says McKenna. A frequent situation he sees among clients with serious liquidity issues is supplier cheques released in the afternoon based on the customers’ cheques that were received that morning. “They are living on the edge and have no idea whether the situation will be better or worse next week.”

Fiscality is an additional, but often neglected, way of bringing in cash. Companies should consider claiming past tax dollars for losses on accounts receivables, inventory or other areas. “It is probably better to take the loss and ask for fiscal compensation rather than to ignore the loss,” says Vincent. He also points to the mounds of dollars that many companies neglect to claim in R&D tax credits for which they could be eligible. “In a difficult year, it can be worthwhile to maximize this credit, especially when you consider that you can recuperate unclaimed credits over the previous two fiscal years.” Firms such as Ernst & Young and RSM Richter Chamberland specialize in identifying all programs and expenses that are eligible for R&D credits.

Cranky 600-pounders
Then there is the fine art of dealing with banks, which is akin to assuaging a cranky 600-pound gorilla. “Banks are very nervous and asking for higher rates, more collateral, more stringent ratios,” says Zalcman. The old equations don’t stand up anymore. For example, the bank might exclude specific clients when financing receivables, or exclude certain categories of inventory or change the aging of inventory it is willing to finance.

This is where the CA as proactive realist can play a starring role. “Don’t surprise your banker,” says Vincent. “The company that just had a downturn and whose accountant calls the banker without a plan in hand looks like an amateur. I’ve been stuck in such situations, and they are the worst.”

The advice is particularly important for the entrepreneur who has never experienced hard times. Such an entrepreneur can become irrational and indignant with a bank he claims he has been loyal to for the past 20 years. The steady hand of a pro-actively realistic accountant, who has kept communications channels open, can work wonders. “Understand what your options are, have your gun loaded and don’t ruin your relationship if you don’t have an alternative,” Zalcman says.

Of course, a key element here is to have an alternative. That can mean opening a channel with another bank, or an asset-backed lender or even a private equity group — though this can prove time-consuming. “Right now, we have lenders soliciting us regularly through e-mail — ABLs, factoring specialists and others,” says Nutik. “It’s an option.”

A/R & A/P
“Many companies are afraid their customers will run out of money,” Robinson says. That translates into two consequences: not getting paid and/or not getting any new orders.

Rick Jamieson, CEO of ABS Friction, a disc brake pad manufacturer based in Guelph, Ont., definitely sensed a slowdown in orders in the US and, to protect the company’s operation, offered his clients a 5% discount if they ordered immediately instead of waiting until the beginning of 2009 to replenish their stocks. This proved to be a most happy initiative. “Since then, the dollar has declined, so he’s already compensated his discount,” says Robinson.

Working pre-emptively with accounts receivable and accounts payable is crucial. “Set appropriate credit limits per customer based on their current financial statements, not their last audited ones, which may be nine months old,” McKenna says. He also proposes that credit limits be strictly enforced, especially as sales staff may be tempted to override the limit to grab the next sale. “And set the limit at such a level that it won’t cause you to go bankrupt if the client doesn’t pay you,” he says. “You don’t want pain to become fatal.”

On the side of accounts payable, the tricks are well known: pay as late as you can without putting your supplier out of business and keep inventory on a consignment basis if possible.

Intelligent cost control
If cash is king, then a penny not spent is a penny saved. All the usual causes of money trickling out of the company are well known and need to be reined in: travel expenses, lunches, furniture, subscriptions, etc. “But don’t be stupid and cut off the coffee machine and don’t completely cancel the Christmas party,” says McKenna.

One particularly sensitive issue is personnel. A knee-jerk reaction is to lay off staff. “I think it should be a last-resort option,” says Vincent. “Better to cut other expenses and keep your people. If there is a costly operation, it is to rehire and bring people up to speed.”

That’s why Guerriero advises his company to invest in increasing the productivity and efficiency of its workers. There’s an immediate cost to it, but it can quickly translate into significant savings, not only because of the productivity gain, but also because it reduces indirect costs such as energy and electricity.

“There’s a strategic reason for being tight right now,” Robinson says. “It gives you more capital, more cash to seize opportunities. And there will be great opportunities in the coming months.”

Hedging margins
Surprisingly, many companies neglect to consider the major cost of foreign exchange differentials. “People will negotiate prices of materials and equipment down to a quarter of a penny, yet they leave loads of money on the table by neglecting to hedge their exchange exposure,” says Mark Frey, vice-president of foreign exchange trading at Custom House in Victoria. The same reasoning applies to a sales contract: an increase of only a few pennies in the value of the dollar can totally wipe out that contract’s profit margin.

“We advise our clients to hedge for the portion that they export,” says Vincent. “I’ve seen clients who publish a price list for their US clients and don’t cover themselves. For example, a $20-million company that exports $10 million worth to the US that doesn’t cover that export amount is taking a big gamble. If the dollar goes down [as it recently did], good, but if it goes up,you could lose your company.”

Some companies don’t hedge at all, such as MDS Power, which has what Vincent calls a natural hedge. “Our imports and exports even out, so we don’t hedge,” says Nutik.

“In our case, it’s more the speed of the change that hurts. Since we have a large inventory, the exchange swings force us into a delicate balance between changing our prices and keeping our clients happy.”

It’s another story at Canadian tour operator Transat AT, which hedges considerably in foreign exchange and oil. The recent fall in both areas caused it to lose on the oil side and win on the dollar side. “The final result is that the gains and losses somewhat even out,” says Transat CFO François Laurin.

Transat is lucky. Some companies lost by hedging the dollar when it was near US$1.10 and closing their forward contracts when it had gone down to US85¢. So hedging can be risky in itself. “Prudent financial managers are being killed right now,” says Jamieson. “They’re being asked, ‘Why did you book so far forward?’ Yet that was the right long-term thing to do. Last year you were a hero, now you’re a bum.”

So hedging is a double-edged sword. You take a chance wielding it one way or the other. But the accountant who simply ignores such a weapon probably takes a bigger risk.

That’s how it will be in the coming months. CAs will have to juggle increasing amounts of risk without cutting their hands and putting their companies in danger.

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Yan Barcelo is a Montreal-area journalist

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