Stress tests for banks can be applied to your business, too, perhaps even helping you survive

Published 4:00 pm Friday, July 10, 2009

Our bank-led recession has taught federal regulators a few things about how things can go wrong.

The recent stress tests that the Federal Reserve applied to major banks in the country were an effort to put what had been learned to good use.

There is, of course, an almost comical, well, duh aspect to the stress tests. They are based on the regulators sudden realization that banks, like the rest of us, are not islands.

We all operate in an interdependent economy that doesnt always bring sunny days.

The new stress tests are designed to look at a banks ability not only to deal with its own internal problems primarily loan losses but also to cope with whatever else an economic storm might bring to it.

This would be a good time, then, for businesses to take their own stress test. The payoff can be impressive.

The stress tests given to the banks are an effort to measure internal and external risk, and businesses can use the same basic categories.

Internal risk is related to your business model and how it is affected by economic fluctuations. External risk is related to your customers, your suppliers, and others that you do business with; how they are affected by economic fluctuations and how that affects you.

The simplest kind of stress test you can apply to your own business starts with this question: What would happen to your business if sales fell by one percent? Not much, probably.

But what would your company look like if sales revenue fell by 5 percent, 10 percent, or 20 percent?

At some point, the decline in revenue would test your capitalization. And that is something you should know about your company: what level of revenue decline can you absorb, and what are the odds that a recession will bring that kind of decline?

Entrepreneurs and managers are very resourceful, and they are going to find ways to cut costs.

And looking at your companys ability to absorb revenue declines, through a combination of capitalization and cost cutting, reveals a lot about your business model not only in terms of surviving a storm but also about its ability to move forward when the economy improves.

The external risk factors are sometimes more difficult to measure, which is why businesses – including banks as it turns out tend to avoid the subject. But while it may not always be easy to attach a specific number to an external risk doesnt mean that it isnt there.

The first type of external risk comes from any changed financial status of your customers.

In a recession, certain types of spending are affected more than others. The more dependent your business is on your customers discretionary income, the more deeply and immediately you will be affected.

In this recession, for example, the restaurants found themselves hit early and hard with sales declines. In some parts of the industry where intense competition had already pressured profit margins pizza restaurants and deliveries, for example the slower sales were especially difficult to absorb.

The restaurant business is a cash business, and the changed financial status of customers is immediately reflected in sales.

This is not always the case if your business sells to customers on an account basis where payment is due later, usually in thirty days. Changes in these account customers financials only become apparent when they cannot or will not pay.

This is not a good situation for your businessfor two reasons. The first, of course, is that it may be difficult to collect your money. The second, which can be equally important, is that it delays your reaction time. Essentially, you have been paying expenses to support a level of revenue that was not real, but instead was inflated by pseudo-sales from which revenue will be delayed or non-existent.

External risks also include the outright bankruptcy of customers, and this can be important whether or not they owed you money.

A stress test should include an analysis of your customer base to examine how dependent you are on top customers. What would your business look like if one, two, or three of them stopped buying?

The financial health of your key suppliers can also present a potential risk. Are there other options for key materials or products and how long would it take to make the substitution?

Stress tests are about as popular as physical exams, for much the same reason: it is an inherently unpleasant process.

But it is an important tool for your business, and in an economic recession when you already have enough to worry about, it can help you adjust and modify your business plan so that you survive and prosper.