The Cash Paradigm

…Whether you are new to business and just setting foot on your first mountain or you are an experienced climber, this mountain, this economic crisis, is the highest peak we will likely face in many generations of business. But in the end, it is still just another mountain to be climbed.

As a country, we are now in the second phase of what will likely be four phases of the current economic crisis, each phase worse than the one before. Therefore, it is imperative that everyone, particularly small business owners, understand the economic playing field on which we presently find ourselves.

The first phase was the housing crisis. The seeds of the housing crisis were laid in the late 1990s and early 2000s. First, there was a push to make it easier to get a home loan by relaxing some of the standards required for approval. Freddie Mac and Fannie Mae reduced down payment and qualification requirements, thereby making it easier for more people to get into a home with less savings. Precipitately, home ownership went up. Then, in the wake of the September 11th attacks, the country was moving toward a rather severe recession.

In an effort to mitigate the recession and avoid another round of “stagflation,” the Federal Reserve Bank reduced the cost of funds to next to nothing. This meant a substantial amount of very inexpensive and easy-to-get money flooded into the marketplace in every sector of our economy. Almost anyone could get a loan to buy a home with very little or no down payment. This drove up housing demand, which in turn drove up housing prices. Higher prices still did not slow demand because interest rates were so low that the monthly loan payments were still within reach of most Americans.

Demand quickly outpaced supply, and the market scrambled to keep up. We had a residential housing development and construction boom the likes of which this country has never seen, creating millions of jobs in that sector. The rise in housing values, coupled with the ease of acquiring credit, benefited existing homeowners as well; they could now readily access their newly acquired home equity wealth and use the money to buy flat-screen televisions, a new swimming pool for the backyard, that trip to Disney World, etc.

The benefits of the housing boom, which was created by a credit boom, began to fertilize the entire economy. The lush tropical rainforest that was the housing market spread like mad into nearly all sectors of our economy. The flowers bloomed, the sun broke through the clouds, and there was a great deal of low-hanging, ripe fruit for nearly everyone in the economy to take as they wanted. During this period, the biggest struggle for business owners was how to organize their day-to-day operations in a way that allowed them to handle more and more of the work available (i.e., increase production capabilities and efficiencies). Little focus was given as to how to organize businesses to be more competitive with regards to cost controls, pricing and sales engineering. This was the case for small and big business alike.

Everyone became so intoxicated with success that they began to take extreme risks. The banks began to create new and extremely risky loans, like “liar loans,” where individuals did not have to prove that they actually had enough money to repay loans as long as they had decent credit scores. Adjustable-rate mortgage loans with very low introductory rates designed for those with poor credit and high debt-to-income ratios were given to individuals based on their ability to pay the monthly mortgage at the low introductory rate as opposed to the much higher rate they would have to pay later. There were “interest-only” loans in which one only had to pay that month’s interest payment without paying off any of the principle of the loan, which again made it possible for individuals to acquire houses they could not otherwise afford when the principle came due. Needless to say, this led to a rise in home loan defaults.

One must understand how the home mortgage system works in the United States to understand how the foreclosure down the street nearly brought about the overnight collapse of the entire developed world’s economic structure.

When you obtain a mortgage through a mortgage broker, the broker is merely facilitating the loan between the borrower and what is called a wholesale lender (i.e., mortgage banks like Countrywide or Centex). If you decide to obtain a loan from a local bank, these banks only have a limited amount of money to lend in this way. Once they make $100 million worth of loans, for example, they run out of capital and are no longer in the mortgage-making business unless they can sell the mortgage contract to someone else and use the proceeds to fund a new loan in its place.

Overall, there are two types of mortgage loans that banks can make: conforming or nonconforming (also known as “subprime”). The difference between these types of loans lies in who will buy these mortgage contracts from a bank. The primary purchasers of loans in the United States are Freddie Mac and Fannie Mae, and they have specific risk tolerance criteria that banks must use when approving the loans before they will buy them (i.e., the bank’s loan approval criteria must “conform” to Freddie Mac or Fannie Mae standards). Hence, when a bank is able to sell its loans to one of these loan purchasers, it is said to be “conforming loans,” meaning that the bank is conforming to Freddie Mac or Fannie Mae standards for risk exposure.

The second type of mortgage is the nonconforming, or subprime mortgage. This is a loan that is considered too risky for Freddie Mac and Fannie Mae to market as a safe investment. This means the banks that offer these subprime loans have to sell them to a company that is willing to take the higher level of risk involved in order to make a higher profit, which is why these types of loans have higher interest rates.

The only institutions that had enough money to buy these huge blocks of subprime loans and take the higher level of risks involved were Wall Street or comparable sectors in other countries. As such, Wall Street brokerage firms like Lehman Brothers bought these subprime mortgaged-backed securities and resold them. In order to make these higher yield, higher risk investments more attractive for resale to the risk averse institutions like AIG that held all the cash, trusted rating agencies like Moody’s were paid to rate the investments as safe. Moody’s and others then sold out their integrity and independence by accepting a fee to rate these investments, thereby creating a conflict of interest in their rating process that made them biased toward rating the investments as safer than they actually were, to keep the income from the banks rolling in. Freddie Mac and Fannie Mae were now forced to compete for the same buyers, so they relaxed their loan standards in order to compete with the subprime market.

Eventually, these subprime mortgages began to go bad. When they did, foreclosures increased, causing a full-blown housing crisis in which hundreds of thousands of Americans working in the housing sector began losing their jobs, and millions of Americans suddenly lost the only real source of wealth they had—the equity in their homes.

When Freddie, Fannie, Lehman Brothers and AIG all collapsed in this interconnected way, it sent shock waves through the entire global economic system. Banks stopped lending to each other because there was no way of knowing which bank was going bankrupt next, and who would be taken down with them. In fact, we were, and in many ways still are, within days of a potential collapse of all the major financial institutions in the world because of the interconnectedness of these financial weapons of mass destruction. If banks are not lending to each other, money is not flowing to the companies and economies that have come to depend on the flow of credit for survival.

This then moves us into the next phase: the credit crisis.

The credit crisis is worse than the housing crisis, as our entire global financial and economic system has been based on the easy flow of credit for decades. Not only is it difficult for an individual to currently obtain a loan to buy a house, one can hardly get a car loan or a credit card. Furthermore, it is not just individuals that are affected. McDonald’s Corporation, arguably one of the most sound and trusted companies in the world, cannot obtain a loan to put coffee machines in its stores.

The sad reality is that it has been so easy to get a business loan or line of credit over the last decade that businesses did not have to be good at managing all of the eight drivers of cash flow (sales growth, gross margins, SG&A costs, A/R, A/P, inventory, capital expenditures and taxes). Instead, businesses could get by with incomplete management, organizational systems and processes because a bank’s money would cover their lack of management skills.

Managing all eight drivers of cash flow effectively means we have a great deal of capital available from internally generated cash. Not managing all eight of these drivers effectively means that we may not have much internally generated capital in our bank accounts, even though there are substantial profits and sales on our income statements. This means we must access externally generated capital (i.e., a bank’s money) to cover the growth, and sometimes the operating costs, of our businesses. This is capital the banks were only too ready to provide. In fact, the banks were so happy to provide business owners with this money that they were able to convince owners that their companies were not performing bad business by borrowing money to grow and/or sustain operations.

In a market where you could acquire money with almost nothing more than a wink and a smile, you could get by just fine by solely concentrating on growing sales and profits since the banks had all the actual cash you might need. But when that flow of credit was turned off, only the businesses with significant cash on hand and low debt service loads were in a position to comfortably survive. These companies fought the fight in order to successfully manage all of the key areas even when they did not have to. Unfortunately, these examples are rare, and most companies are in trouble, with a very high percentage being forced to close their doors and let their employees go. If this is not happening to you, then it is happening to your vendors and clients.

This then pushes us into the next phase of this crisis: the unemployment crisis.

The consensus amongst all the leading economists in the country is that we will be lucky if we end up with nine percent to 13 percent unemployment over the next year. This might not seem so bad, but all one has to do is travel to Michigan to see how devastating nine percent unemployment is in our economy. Not only does it mean that nine percent of the workforce cannot find jobs, it also means that about another 60 percent of the economy is now under-employed. Individuals who earned $100,000 salaries, for example, now earn $35,000 salaries just to put food on the table. These individuals are certainly not doing any discretionary spending to stimulate the economy. Unfortunately, they are barely getting by, if at all. Michigan is practically an economic wasteland with approximately nine percent unemployment now imagine 13 percent unemployment nationally.

It is important to note that during the Bush administration, the unemployment calculation was changed. Currently, anyone unemployed for more than six months is no longer counted as unemployed, as that person is no longer considered a potential worker. When you add these individuals into the calculation, you generally see numbers running about two percent higher. That puts the “real” projected unemployment numbers between 11 percent and 15 percent.

What is really concerning is that so far, every time we have reached a consensus as to how bad the economic news might be, the news proves to be significantly worse than expected.

We now have a housing crisis, a credit crisis and an unemployment crisis occurring all at once, and now that the unemployment crisis has begun, the credit and housing crises become increasingly worse. We have a compounding economic crisis, which is further compounded by the fact that we live in a global economy, and the rest of the world has the same issues but with less capacity to deal with them.

The first three phases of the overall economic crisis all precipitate and overlap each other, each of the later phases making the preceding phases worse. It is likely that the looming fourth phase will not hit us until the other problems begin to clear up. Yet the fourth phase may be worse than all the others combined. This phase is known as the monetary crisis. Whenever an economy adds new money to the monetary supply, it waters it down or reduces the value of the existing dollars in the system (i.e., the purchasing power of the dollars in the system goes down). The ability to purchase less with the same amount of money is known as inflation. Prices going up, or the value of the dollar going down, causes you to purchase less for the same amount of money. In other words, the more money you “create” and pump into the monetary system, the more diluted the dollar becomes, forcing you to purchase less for the same amount of money.

So far, in response to the economic crisis, the Federal Reserve Bank has created and diluted our monetary supply with more than $1.5 trillion new dollars to pay for these seemingly weekly bailouts. (The federal government does not have, and cannot borrow, enough money to pay for these bailouts, so it must print the money instead.) It is expected that before everything is said and done, we will have diluted the monetary system in the United States by more than $5 trillion.

The businesses that have enough skill and flexibility to survive the next two years will be facing, and functioning in, nothing less than a new financial and economic world order. The economic growth we have become accustomed to will likely to be a thing of the past, as growth requires capital, and capital is gone.

We have seen many of these cycles over the last century, but this one is far worse than any other. Our economy became almost entirely based on the flow of loose, easy credit. Entrepreneurs did not have to learn the highly evolved skills of cash flow management because they could simply get a loan to cover the cash flow shortages that rapid business growth creates.

Loose and easy credit dummied down the business skills and discipline that it takes to be a successful business owner in a cutthroat, competitive environment. We did not have to build a solid aggressive sales process because there was more work than we could handle, and we did not have to measure and control all our costs because in an environment where everyone is making significant amounts of money, price competitiveness is not as important. We did not have to as aggressively negotiate paying and receiving terms with vendors and clients because we could easily get a line of credit when we created a cash flow shortage for ourselves. We kept too much money tied up in inventory for the same reasons.

Finally, we did not have to worry about making sure we had as much cash in our bank accounts as we had profit on the books since almost anyone could acquire financing to buy a business for big dollars later down the road. In other words, many business owners figured they could defer their personal wealth building for the time being (available cash required), and cash out big on the sale of their businesses later. But the wealth left tied up in the businesses is evaporating before our eyes just like the equity in our homes, and the survival of our businesses trumps the idea of selling and cashing out as the grand prize winner in the business beauty contest.

Over the next decade, very few individuals will be buying businesses under favorable terms, and business owners small and large will have to learn to manage their companies with a focus on cash generation instead of profit generation if they want to grow and thrive. Cash is the fuel that keeps your business moving forward. You, your clients and your vendors used to get that fuel from the bank, but now you will have to generate that fuel internally by utilizing strategically focused business management and controls. Those that learn this quickly and make the necessary changes with the most skill and the least amount of trial- and-error mistakes will be the business leaders of tomorrow. The business owners that do not quickly and skillfully adapt will not survive. Instead, they will likely be the new, highly qualified employees of the highly skilled business professionals that did quickly adapt.

My friends, whether you are new to business and just setting foot on your first mountain or you are an experienced climber, this mountain, this economic crisis, is the highest peak we will likely face in many generations of business. But in the end, it is still just another mountain to be climbed. It is an opportunity for greatness for those who choose to seize the chance.

We may lose as much as 50 percent of all small businesses. But when we get to the other side of this mountain—and we eventually will—we will not return to 100 percent of the available business we had before. Instead, we will return to 110 percent or better, as the population is not decreasing. Those that make it to the top of this mountain will have 110 percent of the work available with possibly as little as 50 percent of the competition. The 50 percent that remain will not be those that simply worked harder or put in longer hours. They will be the small business owners that learned the most about themselves and the most about the skill needed to operate a business in the most difficult of environments. The road is steep and the challenges are great, but for those of us that saw the mountain and had to climb it, this is just more of what we ventured out into the world to conquer in the first place.