Mitigating the Impact of an Economic Downturn

Kevin Meyler:

As knowledgeable of your business as you are, it's difficult to actually take a holistic view of your business and say, where exactly are we at? Just because the level of change is just so vast, so fast.

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday, but will definitely have to manage for the future.

Armand Capisciolto:

Hello, and welcome to Accounting for the Future. I'm your host, Armand Capisciolto, BDO Canada's national accounting standards partner and leader of Accounting Advisory Services. On today's episode, I'm joined by Kevin Meyler, national leader of BDOs Business Restructuring and Turnaround Services. We're going to have a discussion on managing the current economic environment.

Kevin, welcome to Accounting for the Future.

Kevin Meyler:

Good morning. Thanks for having me.

Armand Capisciolto:

Yeah. It's interesting times we're in right now, I think is a safe way to say it. As I think all of our listeners know, we're experiencing an economic environment that I know myself, I have never experienced before in my working career. I think what is it? Inflation is now, it hasn't been as high since the early 80s. I wasn't working in the early 80s. If I was, I would've been an accounting prodigy, but I was not at that time. And you have high inflation, and we also have interest rates increasing at an extremely fast pace. We all know the Bank of Canada did a hundred basis point increase, which is somewhat unheard of.

So, let's start out by talking about what companies can do to mitigate the impact of this current economic environment they're facing.

Kevin Meyler:

Sure. No, again, I think your comment that it's interesting times might be an understatement of 2022, and that's been a challenging year so far because my crystal ball is murky, I will say that. So, when we're looking at helping companies as they come through this environment, we're kind of taking a step back, because as you highlighted, just the inflation, interest rates, the impact on pandemic, the supply chain, it truly is, and I hate to use this word, but it is unprecedented. So, the companies that we talk to, they're business owners, they're extremely knowledgeable of their business. But what we're seeing is that as knowledgeable of your business as you are, it's difficult to actually take a holistic view of your business and say, where exactly are we at? Just because the level of change is just so vast, so fast.

I think that's the first thing we ask the companies to do, and either directly or through an advisor say, "Let's stop, let's pause, let's take a look. Where are we historically? Let's look at our financial statements and take a bit of a deep dive." So, we do this both on behalf of the companies and even on behalf of other stakeholders, like their lenders. But let's look at the three-year historical results and try and look at it from a segmented business standpoint, because you might have some profitable divisions that are asked by unprofitable divisions. So, to the extent you can take a deep dive and look at where should we be allocating our resources? Because as we all know, the resources of a small business and medium business are all constrained. So that's, I think the first step that we advise companies is just take a pause, look where your company is at and look at it in terms of historical results, and then that will allow you to do some trend analysis that I'd like to talk about later, if that works.

Armand Capisciolto:

Really like the way you put that, so vast and so fast. Nice little rhyme there. It's something we can grab onto. But it really is true, right. This change is happening at an extremely fast pace, but it's not isolated to one industry. It's not isolated to one aspect of the business, right. It's all aspects of almost all businesses, right, which makes it different than the tech bubble of the early 2000s. It's a very different environment.

Kevin Meyler:

Absolutely. And it's not affecting only your business or the people's business that we're talking about, it's affecting their customers, their employees, their owners. So, all these changes are just being forced on people and we're trying to react, but you can't react in isolation because everyone knows that labor markets are changing. You got the supply chain disruptions, and that just impacts the business throughout. So, it's very difficult to manage. And that's where we're here to help is the uncertainty, right, we won't provide certainty to the uncertainty, but hopefully we can mitigate the impact.

Armand Capisciolto:

Okay, Kevin, can you talk specifically about inflation for a minute? Again, it's at a pace none of us have seen in our working life. Are there some specific things companies can do to mitigate the impacts of inflation?

Kevin Meyler:

Absolutely. I think when you're looking at the historical results and analyzing the trends, you can look at a number of things. Number one, the easiest but probably hardest to do is to increase your revenues. Obviously if it was easy to do, people would just do that on their own. But you can also look at is it a simple price increase? And what impact does that price increase have on demand? Obviously the higher you increase your prices, demand might suffer. So, if you're unable to do that, you can look at your cost structure, look at the nature of the increases. So, for example, are you able to renegotiate or perhaps provide alternative suppliers? But if none of those easy fix works, you could look at more holistic things, and that's really taking a deeper dive into your business and conducting an 80/20 analysis. And that's based on the principle that 80% of your profit comes from about 20% of your customers.

We've had success in the past dealing with that on behalf of a company, and it really goes to deep dive into the company fundamentals, and it might even revisit the entire procurement and pricing strategy. We've done that on behalf of a retail company with great success. It might also just be an opportunity to look at design. Can you incorporate less expensive components? Or can you look at improvements in production? Obviously, those are fundamental challenges to a business, but they could be a successful result. And I guess the last one would be the dreaded shrinkflation, which I've experienced in potato chips. That's where you hold the sales price constant, but the size of the product decreases. So those are all quick hits that you might be able to do, but obviously some of them are more fundamental to the business.

Armand Capisciolto:

Any reference to potato chips is perfect, Kevin. I think we've all popped open a bag of chips and wondered, wow, there's a lot of air in here, and there seems to be more air lately.

It's really interesting insights on the 80/20, and it's almost an issue where some of these things you wish companies were doing even in stable times. There's a bit of complacency sometimes in stable times, and maybe these challenges we're facing just force us to look at things that maybe we wouldn't have otherwise looked at.

Kevin Meyler:

No, I agree. Absolutely, because if you're looking at larger picture financials, sometimes the 20% that you might be banking on is really masked by the part that is not as profitable. So, it takes a bit of sometimes a third party, or an independent person, or just owner operators to take a step back and look at it holistically.

Armand Capisciolto:

Leading from that uncertainty, because my role within BDO is on the financial reporting side, so I'm often when we talk about financial reporting, usually someone wants financial statements, and typically one of the reasons they want financial statements is to obtain financing. And I guess when you're working with companies right now, if we're talking about a restructuring in turnaround services, there would often be financing or refinancing that needs to be done. What's that market like right now? With all this what I'll call macroeconomic uncertainty with rising interest rates is, is it more difficult right now for companies that need financing to get that financing?

Kevin Meyler:

Surprisingly, I'm not sure it is, because I think there's just a lot of competition. There's the Canadian banks that obviously are the primary source of financing for Canadian businesses, but there's also a large amount of alternative lenders both in Canada and the U.S. that have what you call a lot of dry powder. So, they're looking to deploy capital. So obviously competition is great for the people looking for financing. So, there's obviously a bit more scrutiny, I'll say from the lenders saying, well, similar to the companies that are trying to map out what the future's going to look like with varying degrees of success, so are the lenders. But I think that's where it's important to not only look at the historical results of the company, but on a go forward basis, make sure that you have a good understanding of where your company's going, not only from a profitability standpoint, but also from a liquidity standpoint.

So, in terms of mapping out your financial forecasting, look at your cash flow forecast so you can map, exactly what it sounds like, your sources of cash with your uses of cash to make sure that your financing is appropriate for what you're looking for. And I think that's important when you're talking to the lenders.

Armand Capisciolto:

That's really interesting when you talk about the banks, they still want to deploy cash, the alternative lenders having cash to deploy. As you talk about those forecasts that you're doing, they're not forecasting. When they are forecasting their cost of capital and they're forecasting their cost of interest though, one of the things I would assume that they have to realize is it's no longer 2% that I'm forecasting my interest expense at. As much as there's competition, has that cost of capital started to creep up for these entities?

Kevin Meyler:

I think it has started to creep up, but that's where when we are looking at this to help a company, what we will do is do a great amount of sensitivity analysis. So, say to get the right type of financing, go plus two plus four, whatever it looks like, just so that you know that you're going to be able to sustain the cost of capital throughout the term of your agreement. Similarly, we'd want to look at what's going to happen if your revenues decreased, what's going to happen if your cost of goods sold, or your labor keeps increasing? Because again, there's no certainty here. So, I think it behooves the company to do that sensitivity analysis on their major assumptions and their major business drivers.

And that's where I think it's incredibly important to map that out before you go looking for financing. And we have an entire group that assists company in evaluating what financing they need and sourcing that at an attractive cost. And that's exactly the exercise that they do so that it matches appropriate with the business needs.

Armand Capisciolto:

So, when I hear scenario analysis and variance analysis, all I think of is a lot of spreadsheets with a lot of tabs.

Kevin Meyler:

But some of them are color coded so it makes it a lot easier.

Armand Capisciolto:

Oh no, color coding. You're talking to a colorblind person here, so just the color coding's always a problem for me. So, sticking a little bit on this financing aspect of this, because one of the areas that I often get involved with situations with companies is, again on the financial reporting standpoint is violation of debt covenants. And we always communicate, wearing my auditor hat, if I'm communicating to an audit client or an accounting advisory client, I'm always saying, you've got to think about these things ahead of time. But as much as we say that we often see companies that don't realize that they're passing or failing their debt covenants until they're completing their financial statements. And from a financial reporting standpoint, just in general, that's too late. If you're finding out about it after year-end, all depends on what accounting standards you're playing, but for the vast majority it means that debt's being shown as current, and then that makes the financial statements look very ugly.

So, it's this managing of covenants, we often see it manifest itself in a financial reporting issue for companies not managing it. Do you have any advice to companies in how they should be managing their debt covenants?

Kevin Meyler:

Yeah. And I think one of the situations that I find myself in is giving advice to a company, exactly as you say, is when you've already tripped it. And then banks typically don't like surprises, and from my experience, they like negative ones even less. So, I think to minimize that, it echoes my earlier comment that to the extent the company's able to map out their predictions of the future, if you will, acknowledging there's no perfect ball, but do the financial forecast, and as part of that map out your covenants. So, map out where you think you're going to be, and then you can do the sensitivity analysis on that, because that'll allow you to both evaluate where you are and where you might be.

Maybe an illustrative example is I was involved with a company before and it was a seasonal business, and they were doing incredibly well, but they kept getting in trouble with their lender because they kept tapping up against the maximum of their borrowing facility because they were almost too successful. And so, we got involved, and it ultimately revolved around the fact that the business was overly seasonal, and it hadn't always been. So, when you looked at their margin covenants, just their credit facility didn't mirror that, didn't mirror that they're going to have a seasonal bulge. So, the lender was able to renegotiate the credit facility to give a seasonal bulge and they're incredibly successful now. So, I think the best thing is just to monitor it and try not to surprise the lender and be upfront and work with them.

Armand Capisciolto:

Yeah. I think it's back to that nobody likes surprises, and especially they don't like negative surprises, in that situation, you're not necessarily going to the bank when it's already blown up. You're going to them in advance. You're explaining the scenario that they're in. You're explaining the need. And in general, people like that because you're eliminating the surprise. But what happens on the others? I'm sure, and it's unfortunate that you get calls from companies sometimes that haven't done that, and they are in violation of a covenant. What happens then when they've actually breached a covenant? What should they be doing and what should they be expecting for their lender to do? And again, how do they manage that?

Kevin Meyler:

I think obviously it depends on the extent of the breach. For example, if they're calling the bank on a Friday and they're not meeting payroll on a Monday, there's going to be a lot less options. But to the extent that they can predict it and it's a minor breach, there's a number of options. The bank may simply waive it. The bank may say, you know what? We understand your story. We understand that we're still comfortable with the business. And the bank may either give a waiver or a breach holiday. And that's one option. The best chance of that occurring is if you are upfront, and honest and forthright with the bank and coming to them ahead of time. The next is the bank may say, you know what? We're going to assign you into what we call special loans group. And that's often just a matter of policy at the internal branch.

So, what would that might happen is you might have additional reporting. You might have incremental monthly, quarterly reporting so the bank can, I guess assess their level of comfort with the business, for lack of a better word, their level of comfort with management. The bank may ask you to enter into a forbearance agreement. So that's where you formally acknowledge the breach of the covenant, may incorporate additional reporting. It may even involve the appointment of a bank financial advisor to assist in a review of the business, similar to what I talked about earlier, taking a holistic view of the business and its chances for success, opportunities for improvement by an independent third party.

Lastly, in dire events where, for example, the company can't make payroll, the bank could simply seek its rights under its security agreement to enforce its security, which would involve typically the appointment of a receiver. Obviously, that would be subject to the company's ability to defend that. So, it all depends on the magnitude of the breach, as well as obviously the nature of the business and the bank's comfort, if you will, with the business.

Armand Capisciolto:

And it really comes back to the comments you were making earlier about managing these things, budgeting, forecasting, putting scenario analysis in. If you're being proactive, you're limiting the risk of it being one of those dire situations, even if you do breach. And I think everybody wants to avoid any problem. We all want to avoid as many problems as we can, but we really, really want to avoid the dire ones. So, I think that's just back to that original comment about how important it is to just be on top of these things and be forthcoming and open with your stakeholders.

Kevin Meyler:

Absolutely. I think some of the most successful restructurings we've been involved in is the company identified the breach in advance of reporting to the bank saying, "This is where we think we're headed. We're going to have an issue." And in certain scenarios, they even engage in external parties such as ourselves to manage that and go to the bank and say, "Look, there's going to be a breach. A, this is what caused the breach. We've identified it. And B, we think we have a solution. This is how we're going to resolve it." So, you're going to the bank with a plan to resolve it as opposed to, here, this is now your problem. We all need to resolve it together. It's more of a we own it, we're not head in the sand, but this is our collective way out. I think those are often the most successful restructurings.

Armand Capisciolto:

That's a really interesting comment. The lenders are always going to be more accepting of a company that understands its own reality, because they know that a company like that is going to do what it has to do to manage that reality.

Kevin Meyler:

Yep. I absolutely agree.

Armand Capisciolto:

Kevin, this has been great discussion. Any closing comments you want to leave us with?

Kevin Meyler:

No, I think generally just, I fully appreciate the difficulties in the current environment. But I will say it's always encouraging and inspiring to see the resilience of the Canadian entrepreneur, because I hear so many companies come in and they're in dire straits, but they're still willing to work and really looking for every avenue to turn things around. And that's what we really like to see is the restructuring and the successful emergence from these turbulent times.

Armand Capisciolto:

I love that, the resilience of the Canadian entrepreneur. Let's make positive thought to end on. Kevin, thank you very much for your insights on this topic. Myself and our audience appreciate your time, your expertise. I'd also like to thank you, our listeners for tuning in today. I'm Armand Capisciolto, and this has been BDO'S Accounting for the Future. Please let us know if you've found this topic interesting and useful and remember to subscribe if you liked it. I'll see you next time.