Interest rate decisions, exchange rate movements and new lending regulations reach every market participant at the same time. What sets companies apart, however, is not being the first to hear about a development but being the first to work out what that development means for the company. The same rate rise may require one company to postpone investment and another to speed up collections, while for a third it may change nothing at all.
This article sets out an approach for assessing economic developments in terms of your own company. It covers which variables affect which items of a company, which questions should be asked for each variable and how those questions can be turned into a scenario plan.
The Difference Between Following Developments and Assessing Them for Your Company
News about economic developments offers information of a general nature. Company decisions, by contrast, rest on the business's own balance sheet, cash flow and customer base. Assessing a development for a specific company means considering it within the framework of the following three questions:
Does the development affect the company's cost structure and profitability?
How large is the impact, and in which period will it materialise?
Which decisions does the development require to be reviewed from today onwards?
The answers to these questions differ from company to company. For this reason, in periods of high uncertainty the soundest approach is to rely on a model built with the company's own data rather than on general assessments.
The Five Variables That Affect Companies Most
Interest Rates
The interest rate determines the cost of borrowing and the minimum threshold against which investment returns are compared. Companies with variable-rate loans feel a change in interest rates directly, while companies with fixed-rate loans feel it when their loans come up for renewal. The points to assess here are as follows:
What share of existing loans is at a variable rate, and how much is due for renewal in the current year?
By how much would a one percentage point rise in the interest rate increase annual financing costs?
Does the expected return on the planned investment remain above the cost of new borrowing?
Exchange Rates
Exchange rate movements affect companies through three main channels: the cost of imported inputs, the burden of foreign currency debt and foreign currency sales revenue. For exporters a rise in the exchange rate can support revenue, but where inputs are imported or debt is denominated in foreign currency, part of that advantage is lost on the cost side. The points to assess here are as follows:
What proportion of income and expenditure is in foreign currency?
Is there enough foreign currency income to cover foreign currency debt?
How quickly can exchange rate movements be passed on to selling prices?
Access to Finance
In some periods the main problem is not the cost of credit but access to credit itself. Banks narrowing credit limits, shortening maturities or asking for additional collateral can leave even profitable companies facing a cash squeeze. The points to assess here are as follows:
How much unused credit limit is there, and with which banks are these limits held?
How much debt falls due over the next twelve months, and how will it be rolled over?
Is it possible to draw on non-bank sources of finance such as investment incentives, development agency support and grant programmes?
Costs
Cost items such as energy, raw materials, wages and rent do not always change at the same pace. A sudden rise in any one item reduces the profit margin directly, to the extent that it cannot be passed on to selling prices. The points to assess here are as follows:
What are the five largest cost items, and which factors does each depend on?
Which cost increases can be passed on to prices, and which cannot?
How has the ratio of fixed costs to sales moved recently?
Domestic Demand
The first signs of slowing demand usually appear in order and collection data before they show up in sales figures. In such periods customers postpone purchases, delay payments and ask for longer payment terms. The points to assess here are as follows:
Which assumptions are the sales forecasts based on, and when were they last updated?
Are customers' payment periods getting longer?
How much of sales depends on a small number of large customers?
From Questions to a Scenario Plan
When the answers to the questions above are turned into several scenarios rather than a single forecast, they become a meaningful management tool. The aim of scenario planning is not to predict the future but to establish in advance how the company would perform under different conditions. To that end, three scenarios are recommended:
Base Scenario: The assumption that current conditions will continue.
Stress Scenario: A situation in which interest rates and costs rise and demand slows to some extent.
Shock Scenario: A situation in which the exchange rate and financing conditions change sharply and collections are delayed.
In each scenario, the cash flow statement rather than the income statement should be updated first. Within this framework, it should be established in which month the company would face a cash squeeze and what the consequences would be if a particular debt could not be rolled over. This approach is the sensitivity analysis used in feasibility reports, adapted to the company's current position. Decisions set in advance for each scenario, such as which investment will be postponed or which credit line will be opened ahead of time, help make uncertainty manageable.
Early Warning Indicators
Some indicators signal possible problems before those problems are reflected in the income statement. The main indicators to monitor regularly are as follows:
Lengthening collection periods from customers,
Credit limits being used in full on a continuous basis,
A narrowing gross profit margin over successive periods,
Inventory growing faster than sales,
Maturing debt starting to be repaid through new borrowing.
When External Consulting Support Is Needed
If the company has an in-house team to carry out these analyses and keep the model up to date, there may be no need for outside support. However, where management is focused on day-to-day operations, the debt structure has become complex or renegotiation with banks has become necessary, an independent assessment makes a significant contribution to speeding up the process.
Nilüfer Arıak, Founder of AKDAN Danışmanlık A.Ş., discussed these issues in two separate broadcasts of the "Sektör Konuşuyor" programme on OSTİM TV. The first broadcast looked at the measures companies and individuals can take in times of crisis and at how SMEs can keep operating through a crisis, while the second covered access to finance, financial support and incentive mechanisms. Under its Financial Restructuring service, AKDAN Danışmanlık redesigns the debt structure together with creditors and works to make cash management more effective. Matters of strategy and management structure are addressed under its Management Consulting service.
Frequently Asked Questions
What does assessing economic developments for a specific company mean?
It means quantifying the effect of a general economic development on the company's revenue, expenses and financing structure. Because the same development has different consequences for every company, this assessment needs to be based on the company's own data.
Is scenario planning necessary for small companies too?
Yes. Small companies generally have more limited cash reserves, so identifying a possible cash squeeze in advance is even more important for them. At the outset, a basic cash flow statement and a study made up of three scenarios will be sufficient.
How often should the cash flow statement be updated?
Monthly updates are appropriate in periods of high uncertainty, and weekly updates where the risk of a cash squeeze becomes clear. What matters in this process is that the statement is prepared on the basis of actual collection and payment dates.
What is the first step to take against exchange rate risk?
The first step is to determine the foreign currency position. To do so, foreign currency income and expenditure, as well as receivables and payables, should be compared. Since risk can only be reduced once it has been measured, pricing, maturity and financing decisions should be made in light of this assessment.
Although economic developments lie outside companies' control, how well prepared they are for these developments is in their own hands. To have your company's cash flow and financing structure assessed under different scenarios, you can get in touch with AKDAN Danışmanlık.
