Pump Up Your Business

Strengthening Your Business in a Weak Economy

By Paul Macaluso, CPA
Companies are facing a most unstable business environment. Financial officers and CPAs advising clients are in a position, however, to provide guidance to distressed—and healthy—businesses on ways to protect and strengthen themselves for the long haul. These efforts will also help position businesses to take advantage of the substantial opportunities that come with economic turmoil. But given today’s complexities, where should they begin?

If your (or your client’s) business is under stress, you must quickly prioritize critical issues, assess the options available to resolve them and develop a realistic execution plan. Common focus areas include rationalizing product lines and cost structures, divesting or closing troubled business units, managing working capital, and potentially restructuring debt and other core operating agreements.

If the business is performing, but needs strengthening to withstand economic trends, you must optimize the revenue portfolio (products and services), reduce and efficiently manage costs, improve cash management to release liquidity into the business, and stabilize your supply chain.

After performing this analysis, many companies struggle with defining a course of action and, more important, securing management consensus on the path
forward. The following steps will help meet those challenges.

Step 1: Identify Major Components
Most organizations can be divided into three categories:

Core: Operations, assets and people that are critical to the company’s prospective business model and operating strategy.
Non-core: Operations, assets and people that individually or collectively represent a valued asset that is not core to the company’s future operations, but could be monetized to generate capital.
Redundant: Operations, assets and people that represent a drain on the company’s capital and should be redeployed or eliminated.

Step 2: Strengthen the Core
Focus on revenue and cost optimization versus pure cost reduction. At the first sign of financial stress, companies invariably cut overhead and related support costs. However, in today’s environment, it’s critical to take a wider view of the enterprise.

At an ever-increasing rate, competitors are reducing prices, customers are extending their payment terms and costs are falling further out of alignment with the sustainable revenue base. Consequently, companies should challenge their product and service offerings from a revenue and direct margin perspective, as well as from a net contribution standard. For example, underperforming product lines, excess production capacity and inconsistent supplier/vendor management standards plague many companies today.

Micromanage working capital and liquidity variables. Cash-flow issues can arise quickly and cause an organization to rapidly go from successful to distressed.
Is the quality of your financial reporting and related working-capital tools sufficient for true cash-in/cash-out, cash-flow forecasting? A simple test is to ask your finance team to produce such an analysis and assess the output against actual results. A bottom-up analysis of the cash cycle can identify opportunities to accelerate receipts and better schedule payments to free cash for core operations or investments to reduce interest costs.

Can invoicing processes be improved? Centralize accounts receivable, accounts payable and procurement process functions in a shared-service center or localized team. Tighten your supply chain processes to avoid stock-outs, overstock, obsolescence and emergency purchases. Identify tax-efficient strategies and other tax-planning opportunities in alignment with your legal structure and industry segment.

Prioritize discretionary spending, including execution of major capital projects. Challenge yourself to ensure any new capital project meets the company’s profile and that the underlying cost and return on investment assumptions are accurate today.

Many successful companies manage major projects by having an independent, objective oversight group monitor progress, milestones and cost reporting. If project financing was arranged, tap this group to identify whether forecasted debt payments will be met, understand debt covenants and make contingency plans—including communicating regularly with lenders.

Protect the company brand. Intellectual property and reputation are some of the most valuable assets in this new economy. When market reputation is not well-managed, the brand becomes an under- or nonperforming asset at best, and a liability at worst. Unfavorable press coverage related to a failed product or service can tarnish brand awareness and serve as a catalyst for consumers to go elsewhere.

Likewise, constant monitoring of intellectual property rights is critical to minimize unauthorized usage that would adversely impact shareholder value.
Economic downturns increase the risk of internal and external fraud due to incremental pressures (e.g. maintaining sales volumes or addressing creditor demands) as performance falters. In addition, cost reductions can affect internal controls and compliance measures, because the level of effort dedicated to these areas often suffers as work force realignments occur and capital is not deployed for the required systems.

For CFOs and CPAs advising their clients, setting the right tone and promoting the desired code of conduct with clear and consistent messaging is key to mitigating fraud.

Step 3: Monetize Non-core Assets
Monetizing non-core assets and operations can generate capital that can be utilized to stabilize or strengthen the core business, and position a company for future success. Successful and timely execution is far from simple.

Prepare the business. Rarely is a divestiture merely the sale of a product line, physical assets or process. Organizational know-how, managerial capabilities, employee engagement, customer relationships and brand equity are often the true value drivers. In today’s market, buyers are extremely cautious and highly focused on their core businesses—and they crave detailed information on any potential acquisition. A company will need to do much more up-front preparation and vetting of the transaction’s value proposition to monetize the desired asset base in today’s economic climate.

Sale preparation starts with clearly defining the transaction team, along with its related roles and responsibilities. If external advisers are retained, an all-hands meeting should be held to establish a critical-path timeline and process by functional discipline (e.g., financial, tax, operations, human resources, etc.). Recurring meetings should be held to monitor progress and address contemplated issues and opportunities. A core ingredient to success will be open and honest communication across disciplines.

The importance of involving seasoned transaction professionals in this process cannot be underestimated. Often, cash basis transaction tax expense reduces the value the seller receives well beyond anticipated levels. Early planning and regular communication between parties can identify and minimize tax leakage in the divestiture process.

Focus on operations. Non-core assets being carved out for sale should be viewed as living, breathing, stand-alone enterprises. Many months may transpire from the moment a transaction is completed until the deal closes. In that interim, intense focus on operations and the proper engagement of management are crucial to maximizing value and minimizing transition risk.

Operationally, separating a business from the ongoing company involves three critical time periods:

Pre-signing. The management team must anticipate operational risks (i.e., interdependencies among products and intellectual property) well before they become disruptions that reduce value. The existence of share service functions—finance, technology, human resources and others—greatly complicate everything from deal valuation to post-deal operation.
Pre-closing. At this stage assets should have been clearly identified and retention plans enacted. Tax planning and structuring must take into account the effect of stand-alone costs, supply agreements and transition services. An effective communications plan is critical to retaining value and will provide insights related to process, approach, roles and responsibilities.
Establishing independence. Independence occurs when the non-core asset group is operating on its own and no longer depends on its former parent even though the transaction has not closed. At this stage it is important to maintain close ties between the seller and buyer as both want input on key decisions that will affect the quality of the operations. A lack of consensus can affect value and jeopardize closing.

Step 4: Eliminate Redundant Assets
First, identify. These are assets that likely cannot be packaged for sale on a timely basis to a strategic or private equity buyer. Redundant assets may include people, idle manufacturing equipment or underperforming brands, as well as the associated manufacturing, warehousing and corporate costs.

Then, move quickly. When the economy is strong, companies are often quick to move on opportunities, expanding infrastructure and payroll. When sales slide or growth doesn’t materialize, companies need to move just as quickly in cutting the excess. There is a natural tendency to resist these tasks until absolutely necessary, but these measures are necessary to preserve the company’s value and to improve the odds of the organization prospering.

Finally, avoid storage. Rather than arrange an asset auction or fire sale, some companies decide to hold on to certain physical assets, often placing them in storage. More often than not, these assets are never placed into service and the storage expenditures become a new class of fixed cost.

Effective Tax Structuring Is Critical
Potential federal and state income and other tax consequences must be considered prior to engaging any transaction. Depressed valuations and growing operating losses may provide opportunities to effect transactions that were historically cost-prohibitive from a tax standpoint, such as a taxable spin-off. In addition, recently enacted and pending legislation (for example, cancellation of debt income deferral and extended loss carryback) intended to stimulate the economy allows for greater flexibility in structuring deals.

In addition, transactions that would not appear taxable in the common sense, such as modifying certain terms of bank loans, could give rise to unexpected tax liability.

State tax laws vary dramatically, and indirect taxes that provide refund opportunities in a down economy, such as property and transfer taxes, can create traps. Tax advisers who are involved early in the transaction process allow companies to minimize their tax liability and potentially reap cash tax benefits.

Opportunities Await
Today’s volatile economy demands that companies continually monitor their operations, and CPAs are critical to that process. Learn to help businesses proactively manage the core, non-core and redundant segments and you will help stabilize and strengthen companies, as well as prepare them to prosper when the economy rebounds.
Paul Macaluso, CPA, is a senior partner in the Transaction Advisory Services practice of Ernst & Young LLP and co-heads the West Coast restructuring practice. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young.