The Pandemic Economy
Most would probably agree the first two months of 2020 were economically strong. But then as the country began to address the COVID-19 pandemic in March, state-mandated shutdowns across the country severely impacted many industries including most, if not all, foundries. Nonessential businesses were forced to close, and the unemployment rate went from 3.5%, a 50-year low, to an astounding 14.7% in two months. The ranks of the unemployed grew to over 20 million! Fortunately, foundries were considered essential businesses and stayed open. Unfortunately, many foundries experienced a significant drop in their product demand. Obviously, when revenue drops, foundry operations, costs/expenses and potentially financing need to be adjusted to ensure ongoing viability.
When a crisis, like the pandemic, occurs, some metalcasters may find themselves asking, “How are we going to get through this? What steps should we take to survive?”
Business turnarounds and pivots are possible in the metalcasting industry and have been accomplished many times. But it takes flexibility and planning.
As you may have done, many foundries applied for and received a Paycheck Protection Program (“PPP”) loan under the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act to help shore up their financial situations. PPP loans from $50,000 to several million dollars would be fully forgiven if the loan proceeds were used to cover payroll costs, most mortgage interest, rent, and utility costs over the eight-week or 24-week period (“covered period”). Most metalcasters are familiar with the program and the forgiveness rules, which included maintaining current payroll levels. Maintaining payroll and making payments for overhead expenses like utilities and rent would ensure 100% loan forgiveness under the program. Accordingly, foundries tried to retain as many workers as possible to get maximum loan forgiveness. Interestingly, many foundries were dealing with lower customer demand, yet they needed to keep their workers busy. So, what happened? Inventories built up! The hope was that, over time, orders would increase from their customers. Will that happen? Only time will tell. The good news is, once forgiven, PPP loan proceeds are essentially an equity infusion.
But what happens if revenues do not return to normal levels and the PPP money runs out? Will revenues come back? What does your 2021 look like? Do your customers even know what their businesses will do in 2021? Will you be able to meet your vendor payments or your current payroll? Worse yet, will you be able to meet your bank covenants? Banks may disallow PPP money from being factored into financial performance. Will year-end financial statements need to be adjusted to meet the bank requirements?
First, understand a little bit about the turnaround (or call it the restructuring) process. As with any economic downturn or major event that causes a significant drop in revenue or increases in cost, it is critical to assess a foundry’s current financial situation and its near-term viability, and we recommend doing the following:
- Immediately prepare a 13-week rolling cash forecast.
- Analyze pricing, costs and margins by product and customer.
- Analyze the operation’s costs.
- Prepare a financial forecast for the next 12-24 months.
As the old saying goes, cash is king. A 13-week rolling cash forecast is a tool to identify all expected cash receipts and planned cash disbursements in the designated period, each week. It is a little like peeking around the corner. The objective is to identify any negative cash flow weeks and how to resolve them. Cash receipts are scheduled based on expected cash collections from customers, usually based on recent history. Cash disbursements are scheduled based on the timing of employee payroll and benefit payments, as well as expected payments to vendors based on stated invoice terms.
Prices, costs, and margins are really a big, big deal for foundries. Be sure to truly know your costs. It is common to hear foundry managers state they know their costs and thus true product margins, when in reality they don’t.
Get Serious About Forecasting
Another common comment from foundry executives is, “We don’t know what our revenue forecast looks like or how much product our customers are going to order.” Rest assured, your customers have a plan, and you need to ask them for it.
Customers constantly pressure their casting suppliers to lower prices or provide “cost downs.” For many foundries, maintaining product margins while labor, materials and overhead costs rise year over year is very difficult. Many foundries are reluctant to raise customer prices annually from fear of losing some customers. But casting buyers need their suppliers to be profitable and viable businesses to ensure their supply chain has no “weak links.” To bring long-term success, do an analysis of product prices, costs, and margins by customer to identify parts with unacceptable margins caused by inadequate prices or high costs (excessive scrap, labor, etc.) is necessary to affect your long-term success. Such an analysis typically results in identifying certain customer parts for price increases or potentially abandoning parts that generate losses for the foundry. Without a doubt, acceptable customer pricing and product margins are one of the most critical areas to review in orchestrating a successful financial turnaround.
What is both interesting and concerning is how many foundries do not generate one-year to three-year forecasts. Nor do they budget or conduct financial reviews. Once a foundry understands its revenue, costs, and margins, the next step is to prepare a 12- to 24-month financial forecast. In preparing such a forecast, you must get current customer demand forecasts for at least the next 12 months. With customer demand forecasts in hand, a foundry can have a much higher level of confidence in its future revenue performance.
Of course, in difficult economic environments, customers can be reluctant to provide a demand forecast; however, if pressed, they will normally provide their best estimates. Through trends, analysis of costs and spending, a financial forecast can be put together that hopefully shows positive bottom-line results going forward. If the report is not positive, it’s time to go back to assess how to make money. You can also project out bank covenant compliance, thus seeing if you may be in danger of violating a covenant in the future.
Ownership and management will now need to monitor actual results against the forecast moving forward, with any negative deviations corrected quickly. This financial forecast will be required by any banking partner to give them confidence in the viability of the company and ensure their willingness to stay involved.
Foundries are not always the most coveted clients for banks. But if you stay within the terms of your agreement—meaning, meet your financial covenants—all is good … most of the time. At times, however, a foundry violates one or more of its financial covenants. If covenant violations have been ongoing for several months, banks tend to grow weary of the situation (“lender fatigue”). They may be willing to forebear their rights and remedies (they really do not like foreclosures) if a turnaround firm is engaged to help guide the company back into covenant compliance. In some cases, banks are willing to forebear only for a short period of time to allow for a refinancing by another bank or financial institution to take place.
Banks need to be managed like your other stakeholders. Foundries may manage this themselves or bring in consultants who help with an overall turnaround effort, including refinancing. Refinancing typically entails putting together a financing memorandum for prospective banks and finance companies, which includes company information, historical financials, company real estate information, as well as its most recent financial forecast and current 13-week rolling cash forecast. If interested, prospective financing partners will sign a nondisclosure agreement with the company, so they can review confidential internal information. Prospective financing partners will typically review electronic documents containing inventory makeup, (i.e., raw materials, finished goods, and work in process), fixed assets, real estate assets, accounts receivable aging, accounts payable aging and any current and long term debt on the books. A prospective bank wants to understand the collateral within the company to support a line of credit and/or term loan as well as the historical and projected financial performance to analyze the company’s ability to cover expected fixed charges (principal and interest payments on all debt) going forward.
As 2021 begins, businesses are still battling the COVID-19 economy worldwide. Are your foundry revenues still significantly off your pre-pandemic levels? If so, have you taken the necessary steps noted above to ensure your viability going forward? If not, you are not alone. Many foundries are in the same boat. But pivoting is possible, and help is available.
This article introduces a series of columns that will be running in Modern Casting discussing contribution analysis, EBITDA implications versus net income, ownership transition, succession planning, business sales and advisory, how to handle customers, effective price increase strategies and more.