How Do Recessions Impact Businesses?

The word “recession” strikes fear in the hearts of business leaders who don’t know what to expect. However, with knowledge comes power. This article examines 10 ways a recession can manifest and impact your business when the next one inevitably arrives.

What Is a Recession?

A recession is a period of time during which economic activity declines significantly. It reduces gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales, according to the National Bureau of Economic Research (NBER). Recessions are part of the natural business cycle, ending when the economy returns to a state of expansion. Less clear, however, is how long a recession will last. NBER has documented 12 recessions in the U.S. since 1950, lasting anywhere from two to 18 months(opens in new tab). Further, the effects of a recession often linger well past its official end.

How Do Recessions Impact Businesses?

The majority of businesses are negatively affected by recessions, economic studies show, though a sizable minority come through unscathed or even stronger. Certain factors, like industry and company size — prevailing wisdom is bigger is better — tend to correlate with how well a business fares during a recession. But there are no guarantees. In fact, a well-positioned small business may fare better than an unprepared large company. Private companies also tend to have a bit more financial flexibility than public companies that are under pressure to meet quarterly earnings expectations.

Nevertheless, businesses that survive and thrive during a recession typically share two common traits: cash reserves and access to capital. Both are common challenges for small and midsize businesses during ordinary times, which is why planning well in advance to “recession-proof” your business for the inevitable next downturn is so critical.

Key Takeaways

• Recessions are periods of declining economic activity that recur as part of the normal business cycle.
• Most businesses are negatively impacted by recessions, though preparation can help minimize the effects.
• Declining customer spending sets off a chain of recessionary business activity, such as reduced profits, job loss, tightening credit and operational changes.
• With support from the right financial systems and strategies, recessions can present opportunities for well-positioned companies.

Recession Impact on Business

A recession ripples through many parts of the economy. When consumer demand for products and services drops, businesses typically slow down operations, in turn requiring less labor and materials, the latter of which then reduces business-to-business spending. As a result, unemployment increases, which further lowers consumer demand. It’s important to note that consumers and businesses still spend during a recession, just at reduced levels and with shifted priorities.

The domino effects from a recession impacts businesses in different ways, among them:

• Reduced profits. Heading into and during a recession, consumer confidence in the economy drops and customers buy less. This softening, or outright drop-off, in demand can cause significant revenue and profit pressure for companies whose breakeven point is higher than the current demand. When sales slow and expenses remain constant, profits fall or dry up entirely. While every business has its own ability to withstand a period of reduced profit or losses, the longer the recession lasts, the more likely it will become problematic.

  Reduced profits during a recession also make it difficult for business owners to reinvest in their companies, causing a hangover effect even after business begins to pick up. For example, a restaurant that is staffed to handle a certain number of tables per night will likely see its profits decline if only half of those tables are filled due to customers cutting back on discretionary spending. This may cause the owner to delay purchasing new kitchen equipment, which may put the restaurant behind when expansion begins.

• Tightened credit conditions. During a recession, lenders often apply more stringent criteria when assessing the creditworthiness of loan applicants. This can leave some small businesses unable to access much-needed capital. At the same time, tightening credit conditions can result in increased borrowing costs. On the consumer side, customers may face reductions in personal credit or increased interest rates, which can cause them to spend less or delay purchases — which, of course, exacerbates a business’s demand-side problems. Consider a furniture store that uses a revolving credit line to finance its inventory purchases. A reduction in available credit, or a complete revocation of the credit line, can limit the amount of products the furniture store can purchase and then sell to its customers. Limited inventory or stockouts means lost sales. Related, cash-strapped homeowners may not qualify to buy furniture on credit, causing them to forgo or delay purchasing.

• Cash-flow reductions. Getting cash in the door is a perennial challenge for many businesses, but it can become even more difficult during a recession. Customers may take more time to pay because of their own cash-flow issues, and a greater percentage of accounts receivable may become uncollectible. In turn, businesses may not be able to pay their employees and suppliers in a timely fashion. Further impacted by restricted credit lines, businesses may be forced to dip into their cash reserves, making no more than minimum payments on debt and stretching out payment terms as far as they can. The restaurant owner, for example, may continue purchasing food to keep his restaurant open, while also stretching out payments to food suppliers. As a result, the food suppliers’ incoming cash flow slows, too.

• Declining dividends and stock prices. Small and midsize businesses aren’t the only ones to feel a recession’s effects. Public companies face the same revenue challenges, which may cause their stock prices to decline due to lower-than-anticipated earnings results. This is problematic because capital markets are a significant source of funding for public companies. Additionally, when profits are squeezed, dividend payouts may be less than anticipated. This can cause unrest among shareholders, possibly impair the reputation of company management and potentially push stock prices lower.

• Decline in product quality. In an effort to reduce costs and improve profitability in the face of declining sales, business leaders may decide to cut corners on raw materials. Shrinkflation, when a company offers less product for the same price, is also perceived by consumers as a decline in quality. These tactics may help short-term profitability, but they can be detrimental over time. Consumers tend to value quality and durability even more highly when money gets tight, and a perceptible reduction in quality may cause demand to decline even further. For example, a decline in the value proposition for something as necessary as disposable baby diapers could cause consumers to switch to less expensive store brands.

• Employee layoffs or benefit reductions. During the 2008 recession, national unemployment rates nearly doubled, from 5% to 9.5%, according to the National Bureau of Labor Statistics. Indeed, it’s common for businesses to lay off staff or reduce benefits when profits head south and cash flow slows. Small businesses tend to be the first to lay off employees during a recession, but they’re also the first to bring them back during a recovery. Recessions cause companies to reduce labor costs in ways beyond layoffs, too. Some choose to freeze any new hiring and leave open positions vacant. Others hold on to head count but reduce labor hours. And still others may choose to reduce employee benefits, such as cutting 401(k) matching or requiring employees to contribute more to health-plan costs. Of course, strategic, proportional labor reductions or furloughs may be necessary when business activity declines.

• Decreased demand. Decreased demand for products and services is the top reason why companies struggle during a recession, according to an analysis by the Federal Reserve Bank of New York. While that may seem obvious, it is also the most uncontrollable factor business owners face. Ironically, business owners tend to cut marketing and promotion expenses during a recession, which is exactly when they should be nurturing customer loyalty and grabbing market share from companies that go out of business. Think about the example of food suppliers that are struggling with slower cash flow. A potential strategy to preserve demand might include offering an early payment discount to repeat customers. By doing so, the food supplier may be able to preserve its customer base, collect cash sooner and potentially increase sales from current customers when the recovery begins.

• Operational changes. Recessions often challenge businesses to do more with less, which often leads them to rethink the ways they operate. From revamping processes and workflows, to automating repeatable work and beyond, operational changes aim to boost a business’s efficiency, reduce overall costs and increase profits. Small businesses are often more operationally flexible than their larger counterparts. Our restaurant owner, for example, might choose to deliver meal kits when fine-dining demand drops to an unsustainable level.

• Marketing constraints. Companies that resist the temptation to entirely eliminate marketing budgets during a recession tend to impose spending restrictions. Those constraints manifest in the focus and tactics used. The challenge is to align all “4P’s” of the marketing mix — product, price, placement and promotion — with shifts in consumer behavior typically observed during recessions, such as emphasis on quality and durability. An example of a typical shift in focus caused by marketing constraints is redirecting efforts related to product placement, or distribution, toward gaining deeper penetration with existing customers, since doing so tends to be cheaper than finding new customers. The recessionary impact on marketing tactics is a shift toward inexpensive “guerilla marketing” rather than expensive media buys.

• Price wars. Lowering prices to preserve market share is a common reaction when recessionary sales begin to soften. But this can set off price wars among competitors, driving profitability down further. Price wars can benefit customers whose price sensitivity is heightened during recessions, but it creates hardships for companies that lack large cash reserves to ride out the unknown amount of time until expansion returns. Additionally, price wars can impact a business’s ability to restore normal pricing when demand picks up. During the Great Recession, producer prices experienced an 8% price decline that took almost two years to restore.

Benefits of a Recession on Businesses

Despite their hardships, recessions aren’t necessarily bad for all businesses, and some even benefit from a recession. Certain industries are naturally more recession-proof than others, such as healthcare, food and beverage, utilities and other so-called “defensive” industries, because customers deem their products essential regardless of economic conditions. But for businesses in other industries, the challenges caused by a recession may drive creative thinking that ultimately strengthens them, making them more efficient, innovative, financially diligent and/or successful when the economy rebounds. Companies also may be able to snag some bargain-priced assets from businesses that don’t make it. Two economic benefits of a recession are:

• Declining inflation rates: A simple definition of inflation is the rate that prices for common household goods increase when the economy is healthy. When demand is high, sellers increase their prices. But during a recession, when demand softens and sellers are more willing to lower their prices to move inventory, inflation typically goes down. Businesses and individuals with cash or credit to spend can benefit from lower prices.

• Low borrowing rates: At the first hints of a slowdown, the Federal Open Market Committee (FOMC), which sets central bank “policy” interest rates in the U.S., lowers its rates to try to slow the pace of the oncoming recession. In turn, lenders lower their interest rates on business loans and lines of credit, as well as personal lending, such as auto loans, mortgages and credit cards. The premise is that lower borrowing rates will spur spending, which keeps economic activity up. For businesses that pass the stricter loan qualifications required by lenders for low-interest credit, a recession can indirectly lower loan payments.

Recession-Proof Your Business With NetSuite Financial Management Software

Knowledge is power, especially when supported by the right financial information. Having visibility into the performance of your business can help you foresee the potential impacts of an oncoming recession, and plan for them. NetSuite Financial Management Software helps keep a company’s books accurate, up to date and accessible at all times. Real-time dashboards allow monitoring of key performance indicators across the business, including headcount and all operational data. Additionally, budget, forecast and what-if scenario tools are there to help.

Conclusion

Recessions are cyclical and generally have a negative impact on many businesses. Declines in customer demand cause revenue complications that ripple through a business’s operations and the economy as a whole. Understanding a recession’s potential impact can help business leaders better prepare and put measures in place to minimize the consequences the next time one comes around.

Recession Impact FAQs

How do recessions affect small businesses differently than large businesses?

Perennial small-business challenges, such as cash flow and availability of credit, can become exacerbated when declining customer demand results in reduced profits. However, a well-positioned small business can fare better than a large, unprepared business during a recession.

What are the impacts of a recession?

Recessions spark a chain reaction of events for consumers and businesses. When customers begin to buy less, business operations slow down. They require less labor and materials, which can result in job losses and weak commercial demand, which leads back to even lower consumer demand. Businesses can suffer from reduced profits, slower cash flow and declining stock prices, among other consequences.

What businesses suffer during a recession?

The majority of businesses suffer during a recession. Certain “nonessential” industries, including travel and tourism, leisure vehicles, personal services, conferences and fine dining, are typically hit harder than “defensive” industries that are said to be more recession-proof. This is because the demand for their products, such as healthcare, utilities, household staples and food and beverage, remains constant regardless of macroeconomic conditions.