Warning - Businesses at Risk from Economic Recovery

An excellent recent article in the ACCA magazine examines an interesting phenomenon - more businesses collapse at the beginning of a recovery than during the depths of a recession. Its all to do with working capital…

Our good friend Hamish McRae is well quoted in the article, explaining how a switch in working capital as demand builds during an economic recovery can lead to good businesses going bust:

‘As demand declines, businesses contract, which reduces their need for working capital: they “live off themselves” as they get smaller. As demand starts to grow, businesses have to increase their production to meet it. Yet if they’ve spent their working capital just on keeping going through the downturn, they find it very hard to spool up when the recovery begins. This crunches their working capital.’

An economic recovery is associated with an increase in demand and an attempt to rebuild stocks and (perhaps) an adjustment to supply capacity - all are potential sources of working capital and (therefore) cash flow problems for businesses who have struggled to stay afloat during a downturn.

Other factors come into play. A recovery typically comes with higher interest rates (bad news for businesses with high gearing). There is a steady stream of articles in the financial media at the moment about which of the leading central banks will be the first to blink and raise official policy rates.

And well-established businesses that have survived the recession suddenly find themselves competing with many new start-up competitors that have been born in the downturn. The market place in a recession can often become more contestable reducing the scale of economic profits available for businesses.

So beware the sunny upturn if and when it arrives!

The article is well-worth downloading and giving to Year 13 students.