CFO Central

Conserving Capital vs. Investing for Growth: 5 Steps to Achieve Balance

By Megan O’Brien, Brainyard Business & Finance Editor
July 30, 2020
Piggy Bank

In short:

  • Stats show big payoffs for companies that navigate the short term without neglecting long-term growth.
  • Finding a balance between defensive and offensive measures is key to surviving a downturn — and thriving when conditions improve.
  • We explore lessons from past recessions, best practices for cost cutting and methods for evaluating capital spending plans.

The National Bureau of Economic Research declared last month that the U.S. economy officially entered a recession in February, as the coronavirus pandemic abruptly derailed the longest expansion on record. In response, most businesses have been forced to delay, scale back or cancel initiatives that require capital expenditures.

But which ones? What lessons do past recessions give CFOs on trimming capital spending while positioning their companies for growth when conditions improve?

Travel back with us to 2010. As the U.S. economy sputtered back to life after the Great Recession, the Harvard Business Review asked just that question. Finding a lack of empirical data, HBR decided to conduct a yearlong project to understand business success factors. For its Roaring Out of Recession report, the team analyzed strategy selection and corporate performance during the past three global recessions: the 1980 crisis, which lasted from 1980 to 1982; the slowdown spanning 1990 and 1991; and the 2000 dot-com bust, which extended to 2002.

The study included 4,700 public companies and broke the data into three periods: the three years before a recession, the three years after and the recession years themselves.

HBR’s researchers found that 17% of companies went bankrupt, were acquired or became private. The majority had not yet regained their pre-recession growth rates three years after the official end of the downturn. Only about 9% prospered after the slowdown, defined as outperforming both their own previous performance and that of their rivals by at least 10% in terms of sales and profit growth.

What did those leaders do right?

A few takeaways from the study: Massive cost reductions don’t predict success. In fact, companies that made significant cuts had the lowest probability — 21% — of pulling ahead of the competition when times got better. But neither does throwing money at the problem: Businesses that invested more than their rivals during the recession had only a slightly better, 26%, chance of becoming leaders after a downturn.

So, with frenzied cost cutting and zealous investing both out, what exactly is the data-approved approach to capital allocation during a recession? The answer is mastering a spend/save balance informed by some prognostication in an environment we have not seen in a century.

What, you thought it would be easy? Remember, just 9% got it right in HBR’s study. Here’s how to improve your odds.

Play Chess, Not Checkers

“Both internally and among our clients, we are seeing two polarizing mindsets forming,” said Eli Diament, founder and director of Azurite Consulting, which offers management advisory services along with data analysis and development expertise. “Defensive, where all efforts involve battening down the hatches and surviving, or opportunistic, where growth ambitions are pushed — albeit stunted by the underlying economics.”

The approach with the greatest likelihood of producing post-recession winners was a combination of those, according to HBR. Companies that pursued “selective defensive measures” and “comprehensive offensive measures” most often found success after the slowdown.

In short, the objective is to mitigate short-term disruption without losing sight of long-term goals. Companies that manage to do both tend to see the most success post-slowdown — an axiom that’s resonating with investors.

Bain Capital has conducted a bi-weekly pulse check on investors since the end of March. When asked what they look for from company leadership teams, more cited a “long-term and strategic mindset and investing” than “liquidity.” In fact, 95% of investors say it’s important for healthy companies to prioritize building business capabilities right now, even at the expense of delivering earnings per share (EPS).

Unfortunately, when it comes to small-to-midsize companies, there’s a decided trend toward playing defense. For many, that’s a necessity, not a choice, as smaller firms often don’t have the funding, cash reserves and other resources available to large corporations. However, there are strategies for cutting costs sustainably, evaluating capital spend plans and identifying areas for continued investment even in trying economic conditions.

Cut In Haste, Repent At Leisure

Cost cutting is inevitable in an economic slowdown. However, a common pitfall is to hunker down into what may be an unnecessary “survival mode,” where costs are slashed arbitrarily.

Cash is king right now, so taking action to bolster liquidity is advisable. However, the short-term cannot completely eclipse long-term plans — hence the need for sustainable actions in the form of adding clarity to operations and cutting costs prudently based on your business reality.

"Too many people give blanket advice to cut what they consider ‘non-essential’ spend, often human resources, marketing and advertising,” said Lauren Couch, principal at asset management firm BOOST&Co. “But these functions can be key to growing a business in a depressed market, when it is really important to let consumers know what your business is doing, why you add value and why they should use you.”

Instead, Couch recommends that companies continue to spend on functions that directly add value — and put aside ones that do not.

“An economic downturn is a good opportunity to look at what spending is not a core function of your business,” said Evan White, founder and CEO of digital marketing agency Neumarkets. “It’s also a good opportunity to stop spending on experiments that don’t further your business’ purpose and goals in the near term.”

White’s advice: Don’t make cost cuts that decrease your market value.

Numerous executives we spoke with echoed that notion. A cost reduction should not compromise or disrupt profitable/core products or services, nor should it prevent the business from rebounding expediently post-recession. Hasty spending cuts, said Couch, will be counterproductive in the long run. For instance, it can take up to six months to hire the right person for a role. Digital marketing campaigns can take six to 12 months to produce ROI, which makes canceling a campaign completely and then restarting an expensive and time-consuming process. No one should be putting out tone-deaf ads, but in most cases, you can adjust messaging and throttle back rather than stopping completely.

In talking with executives, there was one cost-cutting commonality across industries: Real estate. Multiple leaders said they intend to reduce their property footprints in light of the normalization of virtual work.

The inclination towards slashing real estate costs in favor of remote operations isn’t just a temporary money-saver. Rather, we see it as indicative of a major change to how work is both conducted and constructed in the future. In our new Brainyard Summer 2020 Finance Priorities Survey, out soon, just 26% of respondents said most or all finance team members would be required to come back to the office full time once states allow businesses to reopen.

In all cases, words matter. Azurite’s Diament says to put a positive spin on defensive actions.

“Rather than referring to ‘cost reductions,’ we approach it as ‘resource and investment allocation’ — ensuring every dollar is spent effectively,” he said. “Costs have shifted from support functions to growth functions, and resources are doubling down on product enhancements and internal projects to push the business into its next chapter.”

10 Dos and Don’ts of Cost Cutting

Do Don’t
Address operational inefficiency. There may be redundant positions or processes that can be eliminated or restructured for significant cost savings. Cut strong talent. Good, committed staff are hard to find, and even harder to train.
Consider cutting initiatives that are not a core function of your business or are underperforming. Profitability comes to the front of the queue. Cut marketing completely. Consider guerilla social marketing and other inexpensive brand-awareness drivers popular with startups.
Consider taking payments off autopay to better control payment timing. Cancel underutilized subscriptions. Cut technology that helps your team work remotely. Again, there are very affordable collaboration tool options.
Think about the future. Will you need as much real estate? Will some systems be rendered unnecessary? Overlook the small stuff: office supplies, snacks, furniture and that fancy coffee machine stack up in cost.
Be transparent with employees if pay or benefits need to be temporarily cut. Cut areas generating positive cash flow, like sales, SEO or digital ad spend.

Evaluating Capital Spend Plans

The CFO’s first instinct when there’s even a whisper of a recession is to hoard cash. However, as the HBR study shows, there is often opportunity present during a downturn.

“I successfully grew my business during the downturn in 2008 — we were only a couple of years old at that point and actually increased our market share significantly,” said Steve Keighery of his previous business, hipages, which connects consumers with tradesmen. “We were already trying to steal market share from a very dominant business and offered a lower-cost alternative. The recession caused people to cut back on their budgets, and this opened the door for us to convert customers to our service.”

From a metrics standpoint, though, how can companies be sure they’re reinvesting smartly?

We’ve discussed keeping a close eye on profit margins. During a cash crunch, companies need to defer capital expenditures that will be major drains on finances without generating enough offsetting revenue.

How can a CFO help determine which projects to continue, which to stop and which to scale back or shelve for the time being? Use this five-step analysis:

Understand your current financial position: The business has likely been through a tumultuous several months. How has that affected the health of your company? Be sure to examine key KPIs to effectively determine strength in this market.

Analyze future scenarios: Conduct scenario planning to spot potential risks and business impacts. Consider how your state is coping with COVID-19, the possibility of future shutdowns and the fact that we’re facing a decidedly different holiday spending season. A formal scenario planning exercise will inform the viability of capital investments.

Create a standardized business case for each potential capital project: Each investment proposal should be accompanied by a thorough analysis explaining its merit. A business case should identify sources of value by including a detailed rationale and an explanation of alternatives, according to McKinsey, along with a calculation of the expected return or qualitative benefit, timing, context and risk. These metrics should be included in all business cases to aid in comparing value across projects.

This is a deceptively simple concept that often ends up stymying line-of-business leaders as they try to standardize calculations for success across capital spend types. Parameters and standards for a straightforward growth project tend to be easier to compute than spending for maintenance or compliance initiatives. A common metric to include in these cases is net present value (NPV), but be sure to also standardize how you assess cash flow, since that’s the harder nut to crack.

Once standardized with rules and parameters around key metrics, these proposals will help make comparisons and assessments of trade-offs easier.

Categorize: Capital spend plans can usually be categorized as one of five types:

  • Compliance: Projects to help the business comply with regulations, current or pending. Usually a mandatory investment.
  • Sustaining: Improves current processes to close gaps, prevent service outages or increase efficiency. Think implementing automation or codifying a continuous close process.
  • Growth: Increases margins and revenue on current products or services.
  • Strategic: Opens up future growth opportunities and directions.
  • Other: If a project meets none of the above classifications, it likely should be deprioritized for the time being.

Categorization adds clarity into both the goals of proposed projects and how they align with current needs.

Prioritize: Prioritization in capital spending is a best practice for companies in all economic conditions. In good times and when cash is cheap, many projects get approved. Some under-deliver or don’t align with goals. By using the previous steps, companies can rank capital projects to determine which are the best investments during a recession.

5 Questions to Ask When Evaluating Capital Investments

What type of expenditure is this? Is it a compliance, sustaining, growth or strategic investment? How does that categorization affect its priority?
Can this investment be scaled down in scope and still achieve most of its main objectives? Are there lower-cost options?
Will deferring or canceling this plan hurt my company’s competitive position?
How does this plan rank priority-wise compared with other strategic investment opportunities?
What is the business rationale for this capital project? Does it provide value and differentiation for our company during the recession or immediately afterwards?

Smart Areas of Capital Spend During a Recession

There are some commonalities around where successful companies invest during downturns.

Research & development: R&D is often one of the first expenses to be slashed across the board — a bad idea if you expect to scale up quickly during recovery because you’ll fall behind on innovation. High-performing companies in a McKinsey report during the 2008 recession reported the financial metrics, project costs and overall attractiveness of a given market as key factors in evaluating whether to fund R&D projects.

The last point is particularly resonant in today’s recession: Companies need to understand their niches in whatever they believe the “new normal” will be for their markets. Given the difficulty of that, analysts advise prioritizing strategic projects to get to market products that will produce sales in the next 180 to 360 days.

Talent: Where there was a talent shortage is now, in some specialties, the opposite. Amidst layoffs, hiring freezes and the graduating 2020 class, it may be a good time to bring on new talent that would be too expensive to compete for otherwise.

Mergers & acquisitions: Given today’s low valuations, 65% of investors believe healthy companies should actively pursue acquisitions to strengthen their portfolios, whether via new product lines, customer segments or capabilities.

Neal Taparia, co-founder of incubator SOTA Partners, is actively looking for acquisition opportunities for his gaming and brain-training initiative, Soltaired.

“I believe there may be more companies that are willing to sell given the uncertain climate,” said Taparia. “I’m actively trying to find opportunities where we can acquire gaming sites with full leverage, where the operating profit generated from the acquisition will be more than [the associated] costs, which are cheap. In other words, it’s very attractive to acquire and grow inorganically with current interest rates, and we’re hoping to take advantage of that. Also, needless to say, we’re looking for targets we can further grow.”

Intellectual property: If M&A is too ambitious, building up an IP position where the company sees future innovations will help gain a competitive edge as well as the freedom to operate in that area. IP assets can provide significant revenue during and after the slowdown.

Bottom Line

In a very apt metaphor, Bain & Company likened the measures companies must take to steering a race car: “The best drivers apply the brakes just ahead of the curve (they take out excess costs), turn hard toward the apex of the curve (identify the short list of projects that will form the next business model), and accelerate hard out of the curve (spend and hire before markets have rebounded).”

Reining in costs while investing in growth initiatives in parallel is a difficult balance to strike. However, history shows that those that pull it off can expect to be well-rewarded.

Megan O’Brien is Brainyard’s business & finance editor, covering the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Got thoughts on this story? Reach Megan here.

Mark Bianco

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