Behind the numbers

As the economic crisis rumbles on, London Business School has been providing a regular commentary on events and likely scenarios for the future. Chris Higson, Associate Professor of Accounting, provided his insights on the nature of the recession and the types of companies that will be most and least affected

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Key points:

• The last 15 years were an extraordinarily benign period - in virtually all developed economies. This replaced previous phases of boom and bust.

• The best way to understand the impact of recession on companies is cash flow.

• We think of an economy naturally growing, but a large proportion of companies shrink every year. In a recession the process of orderly decline doesn't work.

• It does not necessarily follow that weak companies fail and the strong survive in a downturn.

• When companies need to sell off assets or the company, markets for this are weak.

• Well managed companies are already lean. Less well managed companies will not be forced to become lean. This means that less well managed companies may actually be better placed to survive.

• We now have full global synchronisation. Being a multinational is no longer a source of protection.

Crisis quotes:

"It is running out of cash that makes firms fail."

"Throughout the last 50 years at least 10% of firms have always been shrinking year on year.  In recession the number of firms shrinking  increases significantly -- 75% of firms shrank in 1981. The 10% of worst performers experienced a hit to sales of around 20% or more."

"Normally, many firms are shrinking. They anticipate and manage it. If you look at BA over the last ten or 15 years it was in orderly decline. It knew it was going to happen, so it shrank costs in proportion to sales. This is difficult in a surprise downturn." 

"There is the idea that the strong survive and the weak fail, but it's quite hard if you look at the process and think of the drivers of cash flow to conclude that this is the case. The big issue is what happens to your balance sheet and, in a recession, everything goes wrong in balance sheet management. You can't sell your assets because asset markets tend to close."

"Being acquired and going bust are closely related outcomes in normal times. Sadly, asset markets tend to be closed exactly when you need them to rescue your business, and this has always been so."

"We now have a lean, mean corporate balance sheet culture. The game has been to run as tight a balance sheet as possible.  Inventories as a percentage of total assets in 1980 were around 25%, down to less than 10% now. This lies at the heart of a great paradox.  It's the fat and inefficient who may survive."

"It helps to think of what drives the cash position of a company if you're really going to understand who's vulnerable."

"In all previous recessions banks have made it harder to borrow and have increased the cost of borrowing. They simply become more risk averse. None of that's new; it's the extent of it which is unique, this time."

Chris Higson (chigson@london.edu) is Associate Professor of Accounting at London Business School.