The CFO’s role in navigating the downturn
by Richard Dobbs, Massimo Giordano, and Felix Wenger
Companies—and their CFOs—may have to adapt more radically to the downturn than they now expect.
A global downturn might appear to give companies with sufficient resources an unprecedented opportunity to buy assets or acquire market share on attractive terms. Indeed, many nonfinancial companies seem well positioned to do so, having entered the present crisis with stronger balance sheets than they had in past recessions, when businesses that followed countercyclical patterns of cash utilisation and spending fared much better than those with purely defensive strategies.
Yet this crisis shows signs of being the most dire and unpredictable one since the Great Depression. At the end of 2008, most national economies were experiencing the sharpest fall in consumer and business confidence in 20 years. After an unprecedented five-to ten-year boom, commodities have experienced their steepest decline since 1945. Experts expect several quarters of negative growth and substantially higher unemployment rates. Indeed, for many companies, survival is not a certainty. What’s more, the broader forces at work in the global economy mean that the underlying economics of strategies could continue to shift with unprecedented speed and scale. Such extreme uncertainty demands constant attention, frequent changes in priorities, and strategies that anticipate and respond to a changing landscape.
Against this backdrop, the role of the chief financial officer takes on critical importance. CFOs must use their deep understanding of financials and liquidity to understand how volatile prices and demand will affect the performance of their companies, both to manage potentially lethal threats and to ensure the availability of the financial resources required for countercyclical investments. Most CFOs will need to replace traditional approaches to budgeting and planning with a more aggressive one underpinned by a re-examination of earlier assumptions about earnings and growth and about how deep the downturn will be.
A surprisingly high proportion of companies are still implicitly building their budgets and investment plans on the assumption that they will return rapidly to top-of-the-cycle performance. Many CFOs will need to challenge such optimistic assumptions by asking a few uncomfortable questions.
What’s “normal” performance?
Many executives still have unrealistic expectations about future growth and margins. In general, nonfinancial corporations performed very strongly heading into 2008, having enjoyed much higher profits and return on capital in 2006 and 2007 than at any time in the past 40 years.3 Return on equity, for example, reached 18% in 2007, compared with its 40-year average of 13%. US earnings reached 6% of GDP in 2007, compared with a 40-year average of 3%. While some reversion to the mean is underway, in 2008 performance is still likely to beat the 40-year trend.
Projecting what will be normal performance after the end of the present downturn requires careful consideration of an industry’s cyclicality and microeconomics. CFOs will need to supplement recent averages with an analysis of the structural changes likely to persist beyond the recession. Growth in demand for many natural resources, for instance, could well be structural, and supply capacity is short in the medium term. All this implies that investments in natural resources might be sound. Other industries, such as finance, may be undergoing long-run structural shifts, possibly returning to the levels of profitability and industry scale that prevailed 10 years ago.