Why COVID-19 poses a bigger threat to existence of SME’s than the Financial Crisis of 2007-08

In 2008, a top investment bank the Lehman’s Brothers along with a number of financial managers and institutions collapsed following depreciation in the subprime mortgage market of the United States consequently leading to an international banking crisis. A number of top firms sought bailout to survive this crisis.

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While this crisis threatened the world financial system as analysts speculated a consequent collapse, there was still coverage being provided by a number of sectors. The liquidity bubble was mainly a problem of financial service providers.

Contrary to this, the surging Pandemic that is in more than 203 countries worldwide has threatened the existence of even the smallest firms in the world. We should be ready to face the biggest crisis, beating that of the Great Depression of the 1930s and the financial crisis of 2017-2018 and here’s why.

The Case for the SME that outperformed many in 2019

First, we take the example of a growing business, a manufacturing company that has grown in faster than Uganda’s economy/ due to high demand and increased expansion. The following company financials represent its performance in the past three years with Profit after tax increased by more than 2,020 times from just about Ugx. 14.3 million to Ugx. 303.18 million. Some of its products have outperformed other but that is not our issue. We are here to assess the impact of a pandemic like COVID-19 on this company’s life.

Management of organizations has to deliver against their financial targets. Sales have to increase to show growth and cost to income has to be controlled over time. By year-end, the company’s rate of return was over 44.75% over and above what the stakeholders were willing to take. This company’s price per share assuming Ugx. One (1) billion was listed would be Ugx.4.87 per share at going conditions and could take up debt of as much as Ugx. One (1) billion at the time.

The balance sheet also showed positive numbers as the company managed to increase its assets to more than a billion shillings while being able to meet its debt obligations for the three years..

The Statement of Profit and Loss for the SME for the years 2017,2018 and 2019

What does the future hold for the company?

A thorough financial projection would bring down Profit by 8% considering the economic conditions remained the same. A favorable upturn would push yield of 5.9% increment in profit after tax, while considering the 2021 Ugandan elections were around the corner, the most realistic bottom-line number would yield a 22% fall in profit after tax, although the numbers remaining positive. So, either way, this shows the business would still grow in either scenario with rates of return ranging from lows of 38.37% to highs of as much as 49%.

However, what these business executives had not speculated was what was coming in 2020. While they managed to make significant numbers in the first quarter of this year (2020), they are now left with a hurdle to cross in the next 9-10 months of business activity.

Following, a full country lockdown prohibiting sale of merchandise that is deemed “non-essential”, the executives of this company set aside expectations for the remainder of the year. This lockdown did not only shutter their demand from their biggest customers (hotels, inns, lounges, bars, malls and arcades), it has also weakened the liquidity of most of its secondary markets (individuals) as people look for product for survival rather than entertainment which this brand had leveraged on.

A business that would yield more than Ugx. 600 million in profit after tax in the next five years has been threatened with risk of being extinguished from the market completely if the situation remains the same and here’s why.

Company projections at the end of 2019 for the next five years without the pandemic

When we look at the balance sheet of this business in 2019, the assets had grown from just about Ugx. 932m in 2017 to more than Ugx.1.2 billion. The return on investment for stakeholders was up to 62% in 2019 with asset efficiency of more than 22.4%. Risk management perspective, the leverage ratio was just about 1.53 falling from 4.56 as the company was shifting away from debt and depending more on its operations for sustainability. This also provides a debt cushion in case the company requires more debt financing. This company also had significant debt by the year end which was to be cleared by 2022. Their financial performance in preceding years guaranteed lenders they would be able to borrow a significant amount to finance their assets through expansion of their business which would be benchmark for them to sustain growth for the coming years. This is an example of most of the performing businesses in the country that have seized dominant market share. They are giving stakeholders high rates of return. This however, does not shield them from debt and other fixed costs they have to pay when operating which by now, this organisation had everything intact. The projections showed a growth in profitability over the next five years, 2020 inclusive.

On, 30th March 2020, the presidential directive issued a lockdown of most of the organisations, operations and businesses that were being run and were deemed non-essential in time of a pandemic. However, none of these guidelines protected these organisations from looming troubles. Yet , this organisation has outstanding debt of more than Ugx. 605 million from a commercial bank at an interest rate of more than 18%.

P&L projection if the pandemic persists for more than a year

Given status quo, we have to be prudent as there will be little or no demand for beverages in 2020 with the lockdown hoping this will not go beyond a year. Therefore, our projection assumes no sales will be made by the firm. However, even without sales, the organization will have to part with its fixed costs. Rising fixed costs up to Ugx. 1.12 billion will be recorded by year end including rent costs, employee salaries and other administrative costs. Yet, there is only Ugx. 220 million cash in the bank. This amount of money will also be used to pay Ugx. 108.9 million to the bank to clear its loan, at a monthly payment rate of Ugx.9m. This will lead to a Ugx. 1.2 billion loss by year end if the situation remains the same. This loss will require more than the recurring five years to recover. Yet, it will have to implement drastic measures to offset the negative cash balance on the balance sheet brought about by this one-year shortfall. The projected profits after 2020 would only be acquired if the business doesn’t shut down and/or it receives more than a billion of financing from other sources, debt or equity.

Let’s take a look at the projected balance sheet in time of COVID-19.

Projected Balance sheet during and after the recession caused by COVID-19

A negative cash balance begins at the end of 2020 with a cash deficit of Ugx 1.14 billion. To offset this, the company needs to have its current loan interest and principal payments postponed to the following year. Also, the stakeholders will be required to source more than Ugx. 819 million to sustain the current business operations given they don’t lay off workers, relocate their properties and have remained operating at the same magnitude. With a rent waiver for this business, which rent costs around Ugx. 283m annually for its many warehouses and other statutory payments, they could offset the bill by a significant ratio.

Even if the organisation tends to debt securities by issuing high yield bonds, liquidity in the markets is at an all -time low. Financial institutions (whose impact will be explained in a later phase) are the biggest buyers of these fixed income securities. Right now as the entire economy is on the brink of crushing, fixed income markets are not as liquid as they were a few months ago.

Looking at this organisation’s balance sheet, it’s on life support and might have to seek bail out from government and other institutions by the end of the year of more than a billion Uganda shillings. This is one of many companies out there that are suffering, Yet, manufacturing sector has over 9,000 different firms big and small, all facing the same challenge. This example is of a manufacturer but all Small and Medium Sized Enterprises Face the same challenge. What happened in the United States in 2008 when big fund managers like AIG and Lehman’s brothers could not sustain liquidity is likely to happen in coming months to a number of organisations like this.

How government can offset these effects of systematic risk on SMEs

How can companies overcome the red zone in these trying times

Short Term Fixed Income Securities for Land Lords

One of the biggest problems these firms are facing during these times are costs of occupancy.30% of the fixed costs for the company in our case were attributed to rent for offices, warehouses and other points of occupancy it has acquired. It had however acquired a loan to start developing areas which would offset these costs in the long-term and had a three-year plan to do this.

While most land-lords in the country are not well versed with financial management and how to transfer risk for a positive return, there would be a call for them to issue fixed income securities. Now the government of Uganda’s job would be purchasing these bonds at an interest from the land lords which would be offset by these organisations in the future once the storm has set. Waiving rent would not necessarily cover the opportunity cost that these landlords would incur but promising them interest over and above the discount rate. This would afford these organisations time to recover from these looming costs, reduce on the impact of layoffs and last but not least encourage the landlords to waive these fees

Repurchase Agreements should include interest payment covenants

While Bank of Uganda offered repurchase agreements to commercial banks to offset short term liquidity problems, they should also add clauses that not only monitor the disbursement of these loans but also use them as a cushion for current loans that are outstanding and need immediate repayment within the period of lockdown.

BoU should insist on pushing loan repayments for most organisations and individuals especially those with seasonal loans (loans dependent on seasons like Agriculture and industry that feeds from it) to later dates. This being systematic risk, the borrowers will fail to meet their obligations. Of course, for the case for bank liquidity, we shall cover that in my next sect.

The company FP&A teams need to upgrade their models

With proper training in financial planning and analysis, the risk management teams of these organisations will be able to overcome forthcoming risk by providing for adequately in coming seasons of recession that might or might not be projected.

For instance, elections usually bring a downturn in financial liquidity and based on historical figures can be projected as forthcoming with significant provisioning on part of internal controls, not spending and investing as much towards such periods.

However, for systematic risk that might not be speculated, there is need to add a fourth scenario in your scenario planning and analysis. While we already have best case, base case and worst-case scenarios embedded in their models, a pandemic scenario that assumes zero operational performance while incurring fixed costs should always be embedded to help companies prepare for darker periods. Economic recessions like the financial crisis of 2008 and the looming COVID-19 pandemic should be learning points for many businesses. Otherwise, we might not see great companies in forth coming years.

Download a White Paper on Why COVID-19 poses a bigger threat to existence of SME’s 

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