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Editor’s Note: March 24 Ram Charan and other experts will share a new, multi-disciplinary approach—from communication to pricing to cost cutting—to help your management team fight inflation and win. Join us >
A successful chief executive’s dominant psychology in good times is aggressive, optimistic and oriented toward one goal: profits, EPS or EBITDA. In my experience, many CEOs do not pay deep attention to the balance sheet—working capital, cash, borrowing, financing and refinancing and CAPEX. No one will face greater challenges in managing successfully in an inflationary environment than CEOs. They must not only oversee a major shift in the way the company does business but also a major shift in the psychology and focus of every manager.
The priority must now become growth of real volume, real revenue, not inflationary revenue. A balance sheet in this environment may require—because of cash flow needs—giving up cash-inefficient customers or market share. That means focusing on certain segments of your market that are more profitable and letting others go. Even the more profitable segments will generate less cash than before, so you need to think about how this will impact capital allocation. This can be difficult for some CEOs to deal with psychologically. So, a reminder: The goal is not market share gains for the sake of market share gains, but cash-efficient market share gains that are durable.
To start, the CEO should consider taking the top team for an off-site to discuss and learn the lessons of what inflation has done throughout history, especially in the 1970s in America and Brazil. The goal is to help everyone transition their thinking to a world where the cost of capital and the cost of doing business are both going up at the same time. As a result, you will have two choices: to absorb the impacts or rethink your business model. Pricing, receivables, inventories, narrowing the product scope if necessary, selecting your customers far more carefully—all of these possibilities are now on the table.
Be prepared: You may need to deliberately shrink or exit cash-inefficient businesses and become smaller and more focused. The way the company measures performance, like market share gain and pure revenue growth, may have to be reprioritized and changed. You will have to know the real volume versus the revenue because increases in price disguise and distort that volume. To protect real profitability, you’ll need to revisit key contracts—and change those that lock you into a situation that could lead to a cash shortage. You will need to do all of this and create two or three scenarios right now for 2023. Revisiting long-term contracts for inflation is a very difficult task. It requires courage, logic and excellent relationships with customers. But it must be done.
For public companies, there will be a contraction of multiples in the stock market as inflation comes along. Investors will discount for lower growth and segregate those that have high debt, those that cannot manage their working capital, those that did capital allocation in the context of zero percent interest rates, as interest rates potentially rise beyond 7 percent or 8 percent.
Your market cap will be based increasingly on your real volume, real margins, your real cash flow. If you can top your competition on that basis, you will attract more capital and more investors. So, it is essential that you focus on the market cap and work backwards. What is the right level of debt, of margins, of receivables, of costs—and real prices?
For private companies, who lack the opportunity to be scrutinized by outside analysts and investors, it is even more important to dive into these details.
Not having a working capital/cash goal is perilous now because the most insidious part of inflation is what it does to working capital, trapping cash in receivables and inventories. Almost all customers will do their very best to extend their terms of payment—from 60 days to 90 days to even 180 days or more—and in an inflationary period, this cash trap is costly. Working capital—and these customer relationships—must be managed closely.
The CFO and CEO need to think through how they will handle this. They should discuss whatever else could be coming in the next eight quarters, and how they’ll adapt, including how the company will handle cash generation and capital allocation under various inflationary scenarios—and not just for the first year, but sequentially, cumulatively, for three years.
The CFO can do stress-testing for a variety of scenarios for liquidity purposes. For most companies, this exercise will not be easy because for most companies, there are too many demands on cash. The board and CEO should create a framework for priorities to determine how cash should be allocated.
Ask your CFO sharp questions, such as: If the inflation rate goes from X to Y, what would that do to our cash position and competitive position? If inflation continues, what are the risks to liquidity, if any?
You may also want to commission an outside study of how inflation will impact the company’s end-to-end value chain. No two companies will be impacted exactly the same way by inflation, but since so many companies are linked to one another, it’s critical to understand how it will impact everyone in their ecosystem.
As part of this, it is essential to understand how pricing increases and accounts receivables will affect many companies as a backdrop to your company’s own operations. This extends beyond the changes themselves to the architecture of the changes—who is leading, who is lagging— not just in your sector but in the context of many sectors and subsectors.
Cash management is the keystone to managing in inflationary times, and the you need to have a clear picture of where the cash is coming from and where it is going. Board members and executive leadership should have input into ways to reduce costs, lower their cash break-even point and their cash consumption and should share any information they have about B2B customers whose financial position could adversely affect the company’s business.
Pricing policy is second only to cash management as a priority. An understanding of the pricing mechanisms in place and the availability of a dashboard that gives any member of the executive team or board an instant update at any time makes the task easier and allows the everyone to keep closer watch on financial developments. This is especially true for cash-stripped companies in low-margin businesses, particularly those that have high debt with restrictive covenants.
No matter what, you must continue to build the future even as you focus intensely on the day-to-day immediacies. A disciplined approach to people development and innovation will position the business to leap ahead once inflation subsides—which, in my view, could be five years. How would you become a better company with a better ranking in your industry? That’s an essential question to always keep in mind.