Article 3 - the global credit crisis

This article has been published in a number of places on the Internet.

The global credit crisis

Today’s credit crisis is the worst disruption to the global financial system in the lifetime of almost everyone alive today. This is truly ground-breaking stuff, and no one can be at all sure where it will end.

The fact that governments around the world have been forced to take the extraordinary step of guaranteeing inter-bank loans in an attempt to unfreeze bank-to-bank lending is a stark pointer to the paralysis in international financial markets, a paralysis born of mutual uncertainties about the extent of bank exposures to overvalued or worthless securities. This situation within the financial sector is at the heart of the difficulties being visited upon companies whose forward performance projections are based on assumptions about continuing debt financing.

The implications

As rapidly as this situation has arisen, and as deeply as it has bitten in that short time, we are still in the early stages, and it is almost impossible to predict what will be the full implications and where the turnaround point might be. One thing is already certain, however. The business models on which many companies have thrived over recent years are now dead. Not only that, but businesses whose business models can and do survive will have to cut their cloth to suit the radically changed landscape. Any business owner or manager hanging on and hoping for an orderly return to the status quo ante will be in for a very rude shock.

Businesses large and small will have to revisit business plans and budgets, and especially forward cashflow projections, as a matter of urgency. Any business model based on continuing high - and rising - asset values, and any predicated upon the continuing availability of easy credit, will require serious revision, and very quickly. Any company employing such models needs to go back to basics and completely re-evaluate their business plans from the ground up.

Trading enterprises lucky enough to be selling the necessities of life are relatively well positioned at the current time. Any operating at the whim of discretionary spending patterns, however, are especially vulnerable.

Variables affecting business performance

The performance of all businesses is affected by a range of variables. Some are common to almost all companies in a particular industry or sector – economic growth rates, salaries for administrative staff, material costs, etc. Some are common to a few, while others are specific to the circumstances of particular companies. The net effect of this is that each and every business has a unique matrix of variables which affects its performance.

The need for customised financial models

Identifying what these variables are is fundamental to understanding the implications of favourable or unfavourable movements in their values. Understanding these implications, in turn, can only be achieved through the employment of rigorous and comprehensive technical/financial models.

It is not enough, however, to test movements in one variable at a time. When testing existing or new business models, it is imperative that base-level variables are all accounted for, and that any permutation or combination of variables can be tested simultaneously. This is the only way to assess the likely impact upon financial performance of a range of scenarios, both anticipated and left-field. And it can only be achieved through the use of customised technical/financial models which have been designed specifically for this purpose.

Using revenue projections as an example, financial models which require the insertion of anticipated revenue amounts, without any attention to the base-level variables underlying them, are worse than useless. Such an unsophisticated approach has no place in modern commerce, and certainly not in the wake of the greatest financial crisis we have ever seen. It is only through identifying and attaching values to every base-level variable with an impact upon forward performance that companies can hope to arrive at meaningful revenue projections.

Speedy action, attention to detail and the employment of sophisticated tools is the way ahead for companies worried about their future in the wake of this crisis.