The question, “When is the next recession going to begin?” always gets attention. That’s probably why there’s been so much news about how the inverted yield curve may be signaling the next recession. I thought it would be helpful to educate you with what this might mean and why it’s so important.
First of all, the U.S. government has been running its budget at a deficit for years and to fund that deficit, it requires the U.S. Treasury to borrow money from the public by offering interest-bearing bonds. Typically, in a healthy economy, bondholders demand to be paid a higher interest (also known as yield) rate on long-term bonds than for short-term bonds because the probability that interest rates will change or borrowers will default increases over time. In contrast, bonds that require investors to make shorter time commitments - say three months - don’t require as much sacrifice and usually pay less. Think in terms of a mortgage, a 15-year interest rate is lower than a 30-year home interest rate.
An inverted yield curve is when the interest rates received for longer-term U.S. Treasury bonds are lower than the interest rates received for shorter-term treasuries. People are so worried about the near-term future, they are willing to forego the higher interest rate offered for a shorter-term Treasury note to lock into a lower interest long term treasury bond because they expect as the economy falters, those rates will drop significantly.
The U.S. Treasury offers notes and bonds with maturities from 1 month to as long as 30 years. The inverted yield officially happens when the 2-year treasury offers an interest rate higher than the 10-year treasury - an occurrence that recently happened. The reason this became a newsworthy item is that the yield curve inversion has preceded the last 7 recessions.
What apparently isn’t newsworthy is the fact that the 2 year treasury yield needs to be higher than the 10 year treasury yield for at least 10 straight business days which still hasn’t happened and during the past 7 recessions when it did happen, the recession began anywhere between 12 and 24 months (so it doesn’t happen immediately). So technically, the inverted yield curve recession indicator has not officially started and even if it did, we have about 18 months to prepare, not much of a leading indicator after all.
I think if a recession were to happen, it may have more to do with the rapid increase in debt the U.S. has accumulated over the past few decades. To make it easier to understand, imagine a small business forecasting a $1 million loss for 2019 on annual sales of $3.4 million and expenses of $4.4 million. Last year, this company had a loss of $850,000 and is forecasting a loss of $1.2 million next year. On top of that, this company has approximately $3.8 million in assets and built up a debt of $22.5 million and is now paying interest of $377,000 annually, making it the fourth-largest expense item on the income statement. It doesn’t take an accountant to conclude that this business will eventually fail because no bank or investor will even consider lending to this company. If anything, it begs the question: “How is it possible that this business is still around?” If these numbers came from the income statement and balance sheet of a small business, I’m very confident it would have failed years ago.
If I were to attach six zeros to all of the numbers I just shared, I would be sharing the financial information from the current income statement and balance sheet for the United States of America. The U.S. is on pace to incur a one trillion dollar loss in 2019, has forecasted an estimated loss of 1.2 trillion in 2020, has accumulated 22.5 trillion in debt, has only $3.8 trillion in assets to cover and pays $377 billion in annual interest expense, which has now grown to the fourth largest expense item on the U.S. income statement. This is all happening during the longest expansion period between recessions - over 10 years and counting. This should have been the time for the U.S. to decrease its debt, not significantly increase it.
Even without an economic downturn, these financial statements are going to get worse. The only reason the country is essentially allowed to spend on credit with no apparent limit is that the U.S. currency is currently acting as the world’s reserve or dominant currency. In other words, there’s a consistent demand for the U.S. currency because the world sees the currency as the safest and most stable option. Therefore, they accept it for most international transactions. This is why the United States can continue to print money to fund the annual deficits. If you think about it, the United States’ most valuable exported item today appears to be the U.S. currency.
Having the title of “reserve currency” is a hard-earned honor and privilege, not a guarantee. So when it’s abused, the title eventually is lost. If the United States continues to operate with large annual deficits and pays for it by printing money, reserve currency status will eventually end with a long and deep recession.
I have learned from experience that all small businesses are resilient - even the ones with weak balance sheets on the path to bankruptcy can remain in business for a very long time as they continue to use today’s sales to pay for yesterday’s mistakes. Countries are even more resilient, which means that the United States could continue to pile on more debt for years without causing a recession or affecting its status as the world's reserve currency. So I doubt that will be the reason for the next recession.
So here we are back to the original question of “When is the next recession going to begin?”
President Ronald Reagan once said, “Recession is when your neighbor loses his job. Depression is when you lose yours.” I believe when it comes to your business, you should have a similar mindset about the definition of a recession. In other words, you should stop worrying about the next economic recession because a recession for your business can occur at any time. For instance, if you lose a large customer, or lose a key employee or have a serious disruption in your supply chain, your business may significantly suffer as if you were in a recession (or a depression). I believe you should stop asking “when is the next recession going to begin?”, and start asking, “Is my company recession-proof?”
A recession-proof company is one that can survive a 30% drop in sales for two straight years. If your company is barely breaking even and not generating additional cash flow during this ten-year expansion, you’re not recession-proof. Your business is at risk to fail when the downturn occurs - and it will occur considering economic recessions have occurred on average, every 6 years. And it’s now been over 10 years since the last one.
To be considered recession-proof, I believe your business needs to have an annual net profit (aka. net income) of at least 15%, a current ratio of at least 1.5, and a debt to asset ratio of .75 or lower.
Having a net profit of at least 15% should give off enough cash to consistently add to the strength of the balance sheet. The net profit percentage can be calculated by taking the net profit on your profit and loss statement and dividing by the total revenue. In other words, if you have $1,000,000 in total revenue and you have a net profit of $150,000, your net profit percentage is 15%.
The current ratio is calculated using information from the balance sheet by taking the total current assets and dividing by the total current liabilities. Current assets are all of the items that can or will become cash within the next 12 months and current liabilities are debts that will need to be paid with those current assets within the next 12 months. The higher the ratio, the more current assets, like cash and accounts receivables your company owns than current liabilities owed. These include accounts payables, credit cards and your line of credit. In other words, if you have current assets of $300,000 and current liabilities of $200,000, you have a current ratio of 1.5. A current ratio of 1.5 means you have 50% more current assets to cover your current liabilities allowing you additional working capital to reinvest in the business.
The debt to asset ratio is calculated by taking total liabilities (current and long term) and dividing by total assets (current and long term). A ratio below 1 means your company has more total assets than it has total liabilities. The closer this ratio gets to 0, the stronger your balance sheet. Conversely, a ratio above 1 means you have more debt than you have assets to cover. The higher the number above 1, the less you are in control of your own business because that means the company is borrowing from someone (like the bank) to cover the difference. They, by default, have a say in your business especially if you stop paying them. A ratio of .75 would mean you are in control of your business, have more assets than liabilities, and a runway to work off of if a recession were to hit.
All three of these ratios should take you minutes to calculate considering all of the information is easily found on your profit and loss statement and balance sheet. These ratios are difficult to achieve so if you discover that your numbers are not considered recession-proof, the best time to work on it is when you’re not in a recession - right now!
The first step to becoming recession-proof begins with creating an excel forecast spreadsheet capable of changing the scenarios of your annual profit and loss to simulate a 30% drop in sales revenue.
For example, let’s say your sales drop from $1,000,000 to $700,000. All of those fixed expenses such as rent, labor, utilities, and debt payments stay the same. Fixed expenses don’t care about your revenue - the landlord still wants the rent and your employees still need their paycheck.
Unlike the rent or the debt payments which are difficult to restructure, your labor force is far more in your control. You need to strategize how you would restructure (meaning lay people off) to survive with $700,000 in revenue. Most companies have employees who are marginal at best and remain on staff because it’s more convenient to avoid the pain of letting the person go. Select all of the employees you would need to lay off to bring down your payroll to a level suitable for the $700,000. Now that you have your list,take a look at each individual and ask yourself, “Would my operation see any drop off in service or quality without this person?” If the answer is no then maybe you should be considering letting this person go today instead of waiting for a recession.
The next thing you should do is review all of the transaction detail for every expense item on your income statement. In other words, I want you to download on excel all of the transactions that have occurred on every expense line item on your profit and loss statement and review it. It may seem tedious however, if you have never performed this, you will save thousands of dollars. I guarantee there are memberships you don’t use or need, many commodity-type services like office cleaning, uniforms, insurance or payroll you can negotiate down with a simple phone call and vendors you never heard of. During this exercise, I want you to highlight the cuts you will make today and then highlight the cuts you would make during a recession - and then ask yourself “Why can’t I cut that expense today?”.
Finally, you need to become more resourceful with sales. It’s a fact that your customers don’t know everything you sell and statistics say that the probability of selling to an existing customer is 60-70 percent. Create a sales strategy to work off of that trust you already built with you current customers by making them aware of everything you sell
By having a net income percentage of 15 or higher, a current ratio of at least 1.5 and a debt to asset ratio of .75 or lower, you will be recession-proof and will no longer have to ask “when is the next recession going to start?” You will look forward to the next economic recession because you will have positioned yourself to outlast your competitors while using your strong balance sheet to acquire market share, upgrade available talent and grow faster!
Get started today! I hope you have a great day.