Stress testing your business/livelihood

Among the simulation exercises that are done in strategic planning is “stress testing” the organization’s ability to survive severe or extreme negative conditions, and project the results. These are done during normal times but gain more urgency and importance during crisis, like in the current COVID pandemic and the consequent economic recession. The effects may be in the social, political, and economic consequences but for business and livelihood, it is the financial or economic that is paramount.

Individuals and small businesses do this informally when they assess their ability to continue their business, dig into their savings, evaluate their assets or redefine their sources of income or business. For this discussion we will propose a process and structure that should be written down as a guide. The same process is followed by large companies but they have software and apps that can handle a variety of stress factors to derive projected multi-year scenarios, or sensitivity analysis.

In a crisis, liquidity stress testing takes the front act as it determines whether you can survive for at least 90 days. The starting point is the latest financial statement as it shows where your cash flows are coming and when, your available cash and near cash, the assets that can be readily converted to cash. Then, you input the assumption that your cash flow will be reduced by 25% and 50% in the next 12 months, your accessible bank lines will also be reduced, and you still have to carry your overhead expenses and pay your payables. This will give you an idea of how stressed your liquidity will be in the next 12 months and what you have to do to ease this stress.

The next stress test will be for the solvency of your business or livelihood. This determines if you will have enough Capital to continue your business and is measured by the Capital Adequacy Ratio. Different kinds of business have different ideal capital structures. Manufacturing and property companies who have long gestation projects will need more capital for fixed assets, while trading/marketing companies will need more working capital. Leverage or Debt to Equity ratios, the amount of loans in relation to the owner’s equity matters a lot since servicing the interest and principal of the debt affects your income and cashflow. To stress test your solvency, assume a 25% and 50% reduction in your capital assets and determine what will be left in the owner’s equity. If it is positive, you will still be solvent, if negative that is your point of insolvency, where your assets will not be enough to pay off your liabilities.

The stress test for profitability really determines how well you know your business. If your sales/revenues drop by 25% and 50%, what will happen to your bottom line? What happens to your gross and net margins? What happens if you cannot get your materials and supplies because of supply disruptions or new payment terms? How fast and how far can you reduce your fixed cost and overhead expenses? This is happening to many Small and Medium Enterprise now, so most are temporarily closed. A positive resolution to these issues will give you the indication if the business is worth continuing as it is a profitable business model.

We do stress testing in all aspects of our lives all the time because this is the way we survive. It just so happens that this COVID pandemic is a major stress compounding our regular stresses. But the way to address/resolve them would still be to confront and analytically examine them. If you can solve and survive the worst situations, you will be fine and prosper later.