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Economic Downturn – Boom or Bust

By Michael Vincent

24 December, 2006

The Dimensions of Risk Management Whether we like it or not we are entering an economic downturn, or in blunt terms a recession, how deep or how long is yet to be seen.

I am presently on a trip to promote the Australian concept and practice of risk management, having visited the UK, Belgium, Italy, Hong Kong and Malaysia with Singapore yet to come but having experienced the feelings of the above countries, it is more applicable this month to concentrate our minds on the events yet to overtake us rather than a report on how we rate as regards risk management. As an aside pretty well.

The general feeling in all the countries is of unease, the American economy is slowing sharper than anyone expected and the Japanese economy is all but bankrupt if you agree with the published opinions of the finance industry with at least two major banks bordering on bankruptcy. The two powerhouses of the world economy are entering turbulent times at the same time, a bad lead indicator for us. If you ignore the major indices and visit the real people and industry you find massive sales and stock reduction and few customers, there is a veneer of prosperity but underneath a feeling of impending doom. Here it must be accepted that we are in a normal part of the business cycle that consists of good times, average times and bad times.

Correct risk management and the application of the principles will set the scene for survival in the bad times and prosperity in the good times. But we must plan for survival and it is too late when the recession hits. In other words during the good times we ensure reserves are appropriated for the bad times that must surely come. Therefore risk management is about looking to the future and ensuring survival for the long term. As a risk manager it is now your responsibility to ensure your firm is set to survive and the only way to do that is to undertake a “survival risk audit.” Actions carried out in a timely manner will go a long way to ensuring your firm is here for the next upturn in the business cycle.

A full financial risk audit needs to be undertaken internally to ensure no surprises emerge as the cashflow of the business slows.

Recognise that the paramount concern is the sustainability of the cashflow; survival will depend on the ability to write cheques and pay the wages. Layoffs and staff redundancies should be the absolute last action, as this will inhibit the ability to take advantage of the good times.

Look to your borrowing costs, can the amount of borrowings be sustained into the future, what if the cost of borrowing doubled in the recovery phase? Here is a paradox of recession, as the economy slows interest rates will invariably drop, making it cheaper to borrow. Thus a business may very well survive the recession in the bad times only to fail in the recovery phase because they cannot sustain the level of borrowings needed for survival in a rising interest rate environment.

Try a simple test that is used as a rule of thumb to judge the viability of new entities, double your expected expenses for the next year and halve your income for the same period. Are you in the black or are you entering a period of turbulence.

Next month, some more tips to survive the vagrancies of the business cycle.

About the Authors

Director, Australasian Risk Management Unit
Faculty of Business and Economics, Monash University