Business Cycle Preparation
Nearly every day a new article appears in the newspaper with a position on the current
economic times. ―Markets Swoon on Recession Fears‖ yelled the September 23,2011 Wall
Street Journal headline and ―Dow Notches 12% Drop for the Third Quarter‖ was the highlight of
the September 30, 2011 WSJ edition. So are we in the midst of a double dip recession? Or is
the economy going through another business cycle?
Business Cycles
A business cycle is the economic fluctuation that happens over periods of time. A business
cycle is said to have several stages, typically including a growth phase, followed by a decline,
followed by a turnaround to growth.
Studies show business cycles tend to be about 4 to 5 years in length. This, however, feels a bit
short when compared to major stock market movements, which tend to have about a 7 year
cycle. The 1990s saw a relatively long cycle with a strong down turn in 2000 to 2002.
September 11, 2001 caused much of the down turn, but it was not the only factor – the .com
bubble bursting, the collapse of Enron and the Worldcom failures were also factors. 2007 began
the financial crisis meltdown with 2008 gaining real traction and 2009 being the depth of the
cycle. The point is that indeed between 2002 and 2007/2008 is about 5 years. Thus the
message is that business cycles are indeed a regular part of business.
Are business cycles connected to a particular company?
Yes and no. No, in that the economy is the normal framework that causes business cycles.
Yes, in that a business can have its own cycle independent of the economy. For example, a
business that is related to a commodity can have commodity price cycles. As the price for the
commodity goes up, more participants come into the market or the harvest is extra bountiful and
the price falls, setting off a contraction. Similarly trades can have extra pricing causing
companies to expand, which in turn can create excess capacity. Today the solar power
manufacturing industry is going through such expansion creating capacity in excess of demand.
A company can expand based on perceived market opportunities, but if the opportunities do not
prove to exist, the excess capacity then causes the need for contraction. In technology, product
life cycle is another version of business cycle. One moment the product is leading edge, then a
new technology increased the available options or efficiency and the current product is out of
date and contracting.
Regardless of the reason for or the stage of the business cycle, small business owners face the
daily challenge of making decisions in the midst of this muddle. This paper addresses the need
to understand business cycles and seasonality, the need for preparation for the down cycles,
and the use of forecasting as a business discipline for ensuring sustainability.
Understanding Cycles
There are many types of cycles in business: start-up cycle, product life cycles, industry cycles,
and sales cycles to name a few.
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The Start-Up Cycle
Cathedral Consulting has called the Start-Up Cycle the S Curve™. This cycle hits virtually every
startup business in this pattern: begin strong, grow by 15, 20, or even 30% for a period, then
sales decline, sometimes by 60 to 80 percent. We attribute this to most business’ reliance on
friends and family members of the owners and employees of the company boosting initial sales
revenue. Below is an illustration of the S Curve™.
Key
Revenue
Cri s i s Poi nt
Overhea d (s pent)
Overhea d
(opti ma l )
Peri od of
Revenue from
fri ends a nd
fa miod
l y of
Peri
Revenue from
new cl i ents
(ma rketi ng)
Time
Many small business owners make the mistake of thinking that they are driving their company’s
revenue stream. When businesses first start up, it is not uncommon for them to experience
tremendous growth in the first year or two. Because revenue appears to be streaming in at a
steady rate, business owners project continued upward growth and become anxious about
capacity to meet this growth. Because of the higher revenue the owners begin to increase their
overhead costs (notice the red dotted arrow on the chart above as it creeps up to intersect with
the revenue line) and upgrade—new hardware, new office space, new equipment, etc. But
suddenly, business owners discover that the friends-and-family market is maxed out, and there
is no more growth in revenue. Instead, revenue falls off. The result is significant negative cash
flow.
From a capital perspective, the company burned through the startup capital as planned during
this ―friends and family period.‖ The plan was to be over break-even, but now there is no capital
to fund the continuing and often deepening losses. Many small businesses do not survive this cycle. However, the implementation of systematic marketing and initial capital preservation
along with conservative forecasting can minimize the effects of this cycle.
Product Life Cycles
A product life cycle generally is referred to as introduction, growth, maturity, and decline. Many
new product lines or services that are launched within existing businesses go through a similar
S Curve™. Again, the creation of a marketing plan with a monthly financial forecast can allow
the business to anticipate and prepare for this cycle.
As outlined below for Industry Cycles, a business can develop a series of strategies to continue
to expand the growth of the product by going to new markets or creating product extensions.
Marketing can pay a key role in expanding the market for the product. One client was able to
dramatically expand the market reach of a product that had been in existence for decades by
aggressive media based marketing. Early efforts did have costs exceeding sales, but over time
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the marketing investment has paid off in high enough revenue to give expanded profits. Such a
move for the smaller business is quite brave, and needs to be done in a way that one is not
―betting the ranch.‖ In this case the company had stable profits and could model the marketing
investment against revenue trends. At no time did the company’s income go negative.
Industry Cycles
An industry life cycle often comes in four phases: introduction, growth, maturity, and decline.1
Sales often begin slowly, experience rapid growth, level off as maturation occurs, then begin to
decrease. Businesses often expand to new markets, increase product innovation, or expand
geographically in order to prolong the growth phase. For example, Starbucks began a rapid
international expansion when it had saturated the national market for coffee locations. It also
began experimenting with additional product offerings, such as breakfast sandwiches, in order
to maintain high growth rates to satisfy Wall Street analysts.
Fortunately, the private business owner does not face growth rate pressure from Wall Street.
However, each business is still faced with an industry cycle. For example, the corporate lodging
industry (fully equipped lodging alternative to hotels) experienced this cycle when it experienced
a nearly 40 percent drop in housing units from 2000 to 2002. It then began to grow, dropped
again with the 2007 recession, and then began to rebound in 2010. Cycles have caused
corporate lodging businesses to get creative in managing flexible inventory as well as
differentiating themselves by creating community or adding amenities.2
Sales Cycles
Many businesses also experience seasonality in sales, whether it is the year-end holiday rush
for retailers or the textbook purchasing for publishers and bookstores at the beginning of each
semester. An evaluation of monthly sales and ending cash will allow a business to determine
the seasonality and prepare accordingly.
Preparation for the Down Cycles
While no cycle or season can be controlled, systematic anticipation by the business owner can
allow for preparation for the down cycle. Rarely is high growth sustainable, even if that part of
the cycle seems to last for a long period of time. Part of preparation for the down cycle is the
need to build reserves.
At this point it is hard not to cite the case of Pharaoh and Joseph, where Pharaoh had the
advantage of being warned that there would be a cycle of 7 years of good followed by 7 years of
drought. So a reserve was prepared which was sufficient to carry that nation through the 7
years of drought. Unfortunately, most of us do not have the benefit of being warned of a coming
cycle. Therefore we need to run the business with the assumption that in the near term a down
cycle may begin. This means keeping our companies strong and having reserves.
Much as inventory is built in preparation for the high-holiday season or in a time of growth, cash
reserves should also be built during peaks in preparation for the troughs that are bound to
come. Although it varies by industry, a minimal cash reserve for a small business should allow
for covering at least three months of operating expenses.
1
2
―Industry Life Cycle.‖ http://www.inc.com/encyclopedia/industry-life-cycle.html 110930
Weed, Julie. ―Putting the Staff Up in Style.‖ The New York Times. 19 Sept 2011.
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Strong Financial Systems as the Warning Device
Good financial systems are the next best warning device of where the business is in the cycle.
Monthly financial information, with budgets and with strategic plans set in the context of a
financial model is recommended. The monthly financial information will give management a
timely heads-up as to movements in the market. Comparison of a month to the prior year and
the budget puts the current period in context. If the revenue is up year on year, then expansion
is happening. If the revenue is below budget, then costs need to be aligned and the reason for
the short fall rigorously explored. Budget short falls are warnings that expansion may be over.
Costs must be aligned to actual results in a real time fashion, which financial statements allow.
Good strategic plans with forecasts of revenue, expenses, profit, and anticipated capital
expenditures allow the owner to anticipate the cash needs of the business based on those
assumptions. A good model should allow for several scenarios to be run, a base case that
assumes all is well, an optimistic case that assumes significant increase in revenue, and a
downside case that assumes significant decrease in revenue. Significant for this purpose would
be 20 to 30%. Many companies experienced 40 to 50% declines in the 2009 period. With this
output, the strategy should include action and action points to be taken if either the optimistic
case or the downside case become reality. Such a drill is equivalent to the life boat drill on a
cruise ship. Always remember the Titanic did not need these and was not prepared!
Such modeling allows a business owner to act with a level of certainty in decision making as
actual results can be compared to forecast on a monthly basis and the model adjusted. This
allows systematic preparation for seasonality and cycles.
Anticipating cash needs has two features: near-term and long-term. Small businesses should
know whether they have enough cash to get through the year. This should be part of the annual
budget cycle covered in November, updated quarterly, and current with the business year.
Businesses must be able to anticipate and understand the seasonality of their industry so they
can plan ahead. A successful company, through forecasting, must seek to match their cash
inflow with their cash needs. Maintaining a Cash Flow Forecast is an essential way to gain
understanding about the demands on your company’s cash. (Cathedral speaks to cash flow
forecasting in more detail in our article Cash Flow Management.)
Actions:
1. Review the Strategic Plan, a September activity, for an optimistic and downside case.
2. List the actions the business should take if either case appears to be reality.
3. Review the cash requirements for the next year and compare that to the cash forecast.
Articles for Further Reading
1. ―Business Cycles.‖ http://www.inc.com/encyclopedia/business-cycles.html. This article
further explores the four stages of a cycle and the major factors that contribute to a
cycle.
2. ―Industry Life Cycles.‖ http://www.inc.com/encyclopedia/industry-life-cycle.html. This
article walks through the stages of the industry life cycle.
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director. Sharon
Nolt is a former Senior Associate in the New York Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
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