Featured Insight

Stress Testing for Margin Compression During Economic Volatility

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Ben T. Nicholson

President

  • LinkedIn

At a Glance

Stress testing for margin compression will help businesses gain a better understanding of the affects uncontrolled outward pressure can have on margins.

By modeling a cause/effect sequence the business can be evaluated for the worst-case scenarios and walked back into situation-specific scenarios.

Businesses tend to get in trouble because of recessions, fraud, and stupidity. The latter two are always prevalent, and during normal economic conditions, management’s often forced reality check that “gas prices in Poland have nothing to do with this business in Georgia” can curtail excuses and set the stage for rightsizing an operation. The first challenge, however, is out of the business's control, and while the actual gas prices in Poland remain irrelevant what is affecting them, and other emerging economic challenges, can quickly become legitimate realities.

With economic volatility you never know what’s coming next – a sugar rush or sugar crash – so it is challenging for businesses to make long-term plans and lenders to understand current and future capital needs. Cash flow loans become progressively more problematic, and because asset values fluctuate less than cash flow, ABLs can provide risk mitigation, but disrupted cash conversion cycles result in both the lender and borrower trying to figure out how much cash is needed and when. To dive deeper, there is proven benefit in crafting an analyst mosaic that includes 13-week initiatives to quantify what should happen, and cash conversion analysis to quantify direct internal/external effects. By adding stress testing for margin compression, lenders and their borrowers can rationalize and quantify what could happen.

Reality Check

Consider a confluence of challenges effectively out of a business’s operational control:

  • Sales are distorted because inflation is driving price increases.

  • Cash conversion cycles have lengthened due to increased material lead times, production line labor shortages, and A/R stretched by other customers facing the same issues.

  • Supply chain snarls are leading to disruptions in production timelines which are being compounded by increased material costs.

  • Increased finished goods costs are hitting core business products, lead times are disrupted, and as consumer demand changes, inventory management is challenged.

  • With labor shortage prevalence, wage pressure is increasing as businesses pay more to incentivize retention.

  • With more expensive goods comes higher insurance coverage.

  • Marketing effectiveness is diminishing as social media spends are growing faster than user growth.

  • Rents on both space and equipment are increasing, sometimes with property leases up 20% at negotiation.

  • As interest rates increase, interest coverage is challenged.

  • Container prices from China remain 4x pre-Covid levels.

 

This list is a fraction of the challenges, with no clear end in sight. And when one condition improves another declines.

Clarity in an Anamorphic Image

By adding stress testing for margin compression, the predictive analytics modeling will help lenders and borrowers gain a better understanding of the effects uncontrolled outward pressure can have on margins, especially as they interlink and push against break-even. Results will help businesses craft more explanatory and effective internal and external messaging when strategies must be adjusted.

Consider just a few scenarios and their potential margin impact:

  • With inflation-driven prices, if customers get squeezed what will result from the revenue impact and how will it affect inventory management? How high can prices go?

  • If discounting is initiated to combat decreased sales, what is the compression threshold from increased COGS? If prices are held and sales decline, what is the threshold?

  • How high can fixed costs increase, tested individually and collectively, before reaching a compression threshold, and what is realistic revenue to cover? How will the increases affect variable expenses? If deflation occurs, what is the compression effect from elevated fixed expenses as prices soften?

  • How high can wages increase to stay competitive? Is a path to increased revenue to scale additional labor expenses realistic? What is the compression effect of initiatives to convert to a variable labor cost structure?

  • How high can transport costs increase before product lines need to be dropped? What will be the decreased revenue effects?

  • How much additional interest can the business bear before becoming a “zombie?”

 

When building a retention wall, one stone leads to the next one and it’s the next one you worry about. Stress testing will help highlight how one impact affects the next, and then the next. By modeling a cause/effect sequence the business can be evaluated for the worst-case scenarios and walked back into situation-specific scenarios, particularly as new inputs arise.

Economic volatility is complex and full of uncertainty, but it is not a rationale for a business to not gain a better understanding of its impact. That’s a recipe for getting disrupted, becoming obsolete, or worse, out of business.