The global economy’s sharp contraction during 2008 and early 2009 unexpectedly forced many companies in Asia to focus on short-term survival. Their main concerns were maintaining liquidity and stabilising balance sheets. But while it was a struggle to make longer-term strategic plans in such an uncertain environment, many also wisely took the opportunity to conduct some rigorous house cleaning.
Growth opportunities are now emerging once again, but it is a volatile environment and the prospects for a sustained recovery are still uncertain. C-level executives need to understand the new context, consider whether their existing business models are resilient enough to survive further tough conditions, and whether they have the flexibility to seize opportunities as they arise.
The New Context
Many organisations are still coming to terms with a decline in orders, pressure from longstanding customers to cut prices, pressure from investors and stakeholders to cut overheads, or an inability to secure new lines of credit or collect receivables.
CEOs and CFOs need to accept the possibility that a sharp economic rebound may be unlikely, given that unemployment in the region’s main export markets is likely to remain high and certain key sectors continue to struggle with an overhang of debt and surplus capacity. Bank credit may not become as freely available either as financial institutions are subjected to new capital constraints. Companies will therefore need to manage their finance structures more efficiently.
There may be areas of strong growth around Asia Pacific, but these should not be mistaken for a return to conditions where struggling businesses are quickly refinanced and where growth can hide poor management and governance practices. The fallout of a global recession will be a market with less liquidity, continued downward pressure on costs, erosion of profit margins and cash positions, and reticence in both corporate and consumer spending.
Even so, this is a business climate in which well-run organisations can still achieve long-term success. But to do so, they must be clear now about their market positioning, at board level, at a strategic level and at an industry level. Organisations need to take a fresh look at their competitive environment, the stability of customers and business partners, and reliability of funding sources, all of which have been shaken by the extent of the economic volatility.
New Business Model?
In times of growth, it is all too easy for organisations to break into unwieldy silos, get diverted by non-core business opportunities, and lose track of the broad strategic vision behind the organisation. The economic downturn has given executives the opportunity to dispose of underperforming, non-core assets and generate cash to support the core businesses. It can also be an opportunity to get back to basics and implement changes that improve operational effectiveness and break down silos within a business.
Different silos may have defined strategies that address market share, market penetration, product range (for example rationalisation or expansion), supply chain, procurement and systems. The critical thing for the CEO is to make sure these all contribute to a broader core vision.
Only with such a shared vision in place do CEOs have any prospect of instilling a culture of shared responsibility across senior management and across business functions. Organisations are confronting a more competitive environment in which operational effectiveness is no longer a competitive advantage, but a key to survival.
Where previously there was ample capital available, now it is critical to consider whether capital is being allocated appropriately, efficiently and competently. In the new environment, the CEO cannot just rely on the CFO to answer this question. The CEO himself should seek to understand capital management issues more thoroughly.
Typically, businesses with high volumes, low margins, high fixed costs, high costs for premises and staff, high operating gearing and highly volatile cash flows have been hit fastest in the recent crisis. At the other end of the spectrum, companies with low volumes and high margins were better placed because they had more capacity to cut margins and continue selling.
Management should be challenging whether the organisation has the right capital structure to match its chosen business model. This may seem obvious, but there are many painful examples of crisis-hit companies that failed to realise just how fundamentally their business environment had changed and how that had affected their overall capital structure and accompanying risks. Many companies operating in Asia have complex corporate and debt structures due to the use of offshore holding companies as listing vehicles, and many debt instruments may actually have risk characteristics akin to traditional equity.
While there are signs of a recovery, executives must continue to ask themselves how continued weak performance could affect their company’s financial positions. In cases where debt covenants are at risk of being breached, they need to know how close they are to the thresholds. This is another reason why executives must understand what activity drives what line in the company’s P&L and to make a realistic estimate as to how breaches of debt covenants might lead to a cash crunch.
Financial risk detection should start with the long-term forecasting of a company’s pre-tax earnings. This means examining the company’s back-end to understand business activities and sales records and realistically assess the firm’s P&L accounts. This allows companies to set achievable targets, rather than rely solely on the ‘nice-to-have’ predictions that CFOs may have derived from past data alone. In these uncertain times, it is more critical than ever to conduct a critical and independent review of the reasonableness of the assumptions behind P&L forecasts.
The Way Ahead
While many executives talk optimistically about 2010, a recovery is by no means assured and a double-dip recession cannot be ruled out. Even as economic stimulus packages draw to a close, government debt levels will remain high and consumer confidence will likely remain low. This is not a time to return to pre-crisis patterns of behaviour.
Rather, now is the time for business executives to gain greater visibility into the risks facing the organisation, align different departments and processes, and embed a culture of cash management and cost control. Companies need to fully justify their capital structures and their allocation of capital, giving the balance sheet issues at least as much consideration as income issues, if not more. These are all issues that we at KPMG see our clients grappling with during the year ahead.
About the Author
Paul Brough is Hong Kong Senior Partner at KPMG China. This article is an abridged version of the a report that can be accessed on the KPMG website by clicking here.