The Impact of Recessions on Businesses

Reviewed by David KindnessReviewed by David Kindness

Businesses large and small face declines in sales and profits during a recession. They can also curb credit access, slow collections, and spur business bankruptcies. And while recessions can have disparate effects for different companies, some of the hardships are predictable based on the type and size of the business.

For example, a small consulting firm might experience cash flow issues as clients delay payment on invoices, while a Fortune 500 corporation may be able to save money by cutting jobs and extracting better terms from suppliers.

Understanding how an economic downturn may affect your company or business can help ensure it won’t become one of the casualties of the next recession.

Key Takeaways

• Recessions are significant, widespread, and sustained contractions of economic activity marked by declines in the gross domestic product (GDP).
• Businesses large and small face declines in sales and profits in a recession.
• Their efforts to cut costs may include layoffs and cuts in capital spending, marketing, and research.
• Recessions may curb credit access, slow collections, and spur business bankruptcies.
• Smaller businesses face many of the same recession risks as larger ones, but their lack of scale makes them more vulnerable and increases the risk of failure in a downturn.

Defining a Recession

One common definition of a recession is two consecutive quarters of decline in the GDP. The National Bureau of Economic Research, which dates recessions in the U.S., defines one as “a significant decline in economic activity spread across the economy, lasting more than a few months.” As long as all of these conditions are met to some degree, the NBER is willing to treat them as interchangeable. For example, the severity and pervasiveness of the COVID-19 downturn in the spring of 2020 led the NBER to call it a recession, albeit one that officially lasted just two months.

By any definition, recessions cause job losses and a contraction in economic output as consumer spending and business investment slump.

Recession Impact on Small Businesses

U.S. small businesses have impressive numbers in the aggregate. Defined expansively as those with fewer than 500 employees, they accounted for 43.5% of the U.S. GDP in 2014, though that was down from 48% in 1998. Those with fewer than 100 employees still accounted for 30% of U.S. wages and 35% of employment from 2012 through 2016.

Those figures shouldn’t obscure the fact that most small businesses are tiny. Nearly 40% had revenue below $100,000, and more than 70% generated sales below $500,000, according to Internal Revenue Service (IRS) statistics from 2013. Just 20% of the 29.6 million small businesses counted by the U.S. Census Bureau were employers.

This lack of scale leaves the vast majority of small businesses with less of a financial cushion, market power, and leverage within their industry to weather the tough times a recession brings.

Lenders know that. They are likely to be less enthused about lending to a business without significant cash reserves and capital assets that can serve as collateral during periods of heightened uncertainty and business risk associated with recessions.

Unlike publicly listed companies, small businesses typically can’t raise funds by selling stock in a secondary offering or issuing bonds. In contrast with large employers in high-value industries, failing small businesses also can’t typically lobby the government for help.

As a result, small businesses are particularly vulnerable to spikes of Chapter 11 bankruptcies associated with past recessions. The exception was the COVID-19 recession when pandemic relief measures widely available to employers of every size averted the expected wave of bankruptcies.

Small businesses tend to fare worse than large ones in a recession because they’re less able to withstand a drop in sales amid mounting economic uncertainty.

Recession Impact on Large Companies

Large companies aren’t immune to recessions. In 2020, 244 sought bankruptcy protection, the most since 2009; energy, retail and consumer services were the hardest hit sectors.

As the declines in revenue and profit show up on quarterly earnings reports, share prices may suffer deep declines, since bear markets often accompany a recession and may even precede it. If the profit slump is particularly steep, some companies may be forced to reduce or eliminate shareholder dividends.

Large companies do, however, have more ways than small businesses to combat the declines in revenue and earnings in a recession.

They may reduce hiring, impose a hiring freeze and suspend pay raises, resorting to layoffs to cut costs if all else fails. Companies may also cut capital spending and marketing, curtail research and development, and stop new product rollouts. Such cuts at large companies are likely to have ripple effects on their many employees and suppliers.

One study found that large companies that realize operational cost savings without cutting employees while making long-term strategic investments during a recession tend to outperform once the downturn ends.

Business Effects of a Recession

Many recession effects touch companies large and small. Below we look at some of the most common challenges businesses of any size face in a recession.

Slumping Sales

In a recession, nothing hurts a business quite so much as when the register stops ringing as often, or when orders slow to a trickle. During an economic contraction aggregate demand declines, translating into a drop in sales for most businesses.

Cyclical industries including manufacturing and energy tend to experience particularly sharp declines. Companies with high fixed costs like retailers and technology suppliers face a disproportionate hit to the bottom line as revenue declines.

Manufacturers may face bloated inventories, forcing them to slow output until demand recovers.

The souring of consumer demand lowers the expected returns on investment for advertising and marketing spending, prompting cuts in those budgets. That can lead to revenue slumps for media companies whether they publish, broadcast, or sell ads online.

Credit Impairment and Bankruptcy

One of the first effects recessions have on businesses is the tightening of credit conditions. Faced with a downturn of uncertain severity and duration, lenders turn more selective of the risks they are willing to underwrite.

A recession may bloat a company’s accounts receivable as liquidity issues impact consumers and businesses up and down the supply chain. Customers who owe the company money may be slower to make payments or fail to make them altogether. The company may, in turn, be forced to slow its own payments.

While large companies may be able to refinance their debt at a lower interest rate as the Federal Reserve lowers the federal funds rate in response to the downturn, most businesses face fixed debt service costs that must be met even as sales and profits slump. This is why past recessions have caused business bankruptcies to increase sharply.

Important

Even large businesses may face difficulty rolling over the debt many depend on to sustain operations. Corporate debt relative to the size of the economy has increased dramatically since the early 1980s, boosted by lower interest rates and growing investor appetite for junk bonds.

Employee Layoffs and Benefit Reductions

Businesses large and small may undertake layoffs to cut costs, especially if they need fewer workers to meet the reduced demand for their products and services. Productivity per employee may increase, but morale may suffer as workloads increase while pay gains slow or stop amid the risk of further layoffs.

Wages are sticky, meaning workers are reluctant to accept cuts in pay even if layoffs are the likeliest alternative. In a particularly prolonged and deep recession, however, labor and management may negotiate the cost concessions required to save the company and preserve jobs, including wage and benefit reductions.

If the company is a manufacturer, it may be forced to close plants and discontinue poorly performing brands, necessitating mass layoffs. Automobile manufacturers have done this in previous recessions, for example.

What Is a Recession?

A recession is a significant, widespread and prolonged contraction in economic activity. It is often commonly defined as two successive quarterly declines in GDP. The National Bureau of Economic Research uses a variety of employment, income, and consumption indicators to date U.S. recessions.

What Are the Main Effects of a Recession on Businesses?

Recessions cause declines in sales that can spiral as the resulting layoffs further depress demand. Credit access tends to tighten amid rising economic uncertainty, while loan delinquencies and defaults increase alongside bankruptcies.

Can a Recession Hurt Big Business?

Yes. A recession can hurt companies large and small, though larger ones have more of a financial cushion and more cost-cutting options that can help them weather the downturn.

The Bottom Line

Recessions happen periodically, interrupting economic growth that prevails most of the time. This forces businesses of every size and type to adjust to an abrupt downturn in demand while pruning costs geared for growth. Small businesses have a smaller margin of error than larger ones when a recession strikes. The most capable survivors may increase market share as competitors fail, positioning them for success in the ensuing economic recovery.

Read the original article on Investopedia.