Is Q4 2021 Activity Foreshadowing a Change?
As 2021 is drawing to a close, lenders and borrowers are asking what to expect in 2022. In March of 2020, when the first Covid-19 lockdowns began, there was a great deal of fear and uncertainty, both for individuals and for businesses. As the government pumped liquidity into the market, many businesses used those resources to survive through the period.
Now in late 2021, as the liquidity sources have expired, and businesses must generate cash flow based on their performance, the level of performance stress is increasing. Not only has the “free money” been used, but now businesses are dealing with inflation, commodity price changes, labor issues and supply chain disruption as stresses to their financial performance.
During the past two months, the number of businesses we are seeing with working capital issues has increased. In most cases, these are businesses that qualified for PPP loans and forgiveness or ERC grants, and used those funds to survive but not to evolve. Companies that used the access to liquidity to reimagine themselves, their products, their customers, or their working capital management are in most cases surviving and thriving. But companies that continued to operate in a business as usual manner are likely finding themselves stressed and at a performance crossroad.
The reasons for performance changes
For consumers of financial statements, it is critical to look at 2019 performance compared to 2021 performance, and to clearly identify the reasons for performance changes. The excuses of Covid-19, inflation, labor shortages, commodity price changes, and supply chain may be real explanations for performance changes, but management of a business cannot rely on the excuse. Management must plan for and work through the issues. Lenders should not accept these excuses either, but rather require specific explanations of amounts and reasons for performance changes. For example, rather than say “performance was bad because of labor shortages”, management should be able to say something like this:
Performance in September was impacted by labor shortages. The company operated with 50 fewer people on average than the same time the year before (or 2019) and was were no longer able to maintain a second shift. This impacted our ability to produce product by $x.x, and our ability to generate sales of $y.y, assuming the current margin of Z%.
This type of detailed analysis is what a successful company produces and uses to evaluate next steps.
Is senior management up to the task?
The level of inflation, commodity price changes, labor issues and supply chain issues is unprecedented. For each one of these trends alone the level of impact is something not experienced in 10 to 25 years. As a result, most managers have not dealt with these problems during their work careers, or their management careers.
Combining all these trends at the same time is even more problematic. The level of uncertainty and the amount of analysis and preparation required would stress most people, and requires a leader who is able to calm the management team while directing them to evaluate performance options.
Senior management for many middle market companies comes from the division leaders at larger companies. These senior managers typically had the support of a financially strong parent company who could support unexpected cash needs, and the senior managers may not be used to dealing with not being able to meet expenses such as payroll or vendor payments as those payments come due. These senior managers may also have had the support of a robust accounting and finance team that would prepare the detailed analysis for review, as opposed to having to anticipate the analysis needed and then direct an accounting staff to prepare the analysis.
Looking toward 2022 requires a creative, analytical leadership team who will be able to identify options and the related impact on financial performance and working capital management. Because of the complexity of the problems confronting businesses today, the company and its stake holders will need to be calm and fast as solutions are evaluated and implemented. This year and the next will be a true test of management skills for a generation of managers.