I am old enough, or I should say unlucky enough, to have survived two major recessions. The first in California, 1989, and the second, that one we are all too familiar with, and maybe still smarting from, the Great Recession of 2008. At this point, anyone in the building business should know that we are a vulnerable industry subject to tides much greater than any of us can control, and sometimes currents against which we cannot swim. So it pays to know how far into the next recession you can tread and still have your head above water.

Simple Stress Tests

You have heard about stress tests for banks. It’s essentially an accounting analysis conducted under unfavorable economic scenarios, which is designed to see if a bank has enough money to survive the impact of adverse developments without needing help from Uncle Sam.

Uncle Sam won’t come to your rescue, so a dispassionate look at your personal tipping point is even more important than for the local bank.

The stress test is the opposite of a typical business plan, whereby we dream and look at rosy scenarios of prosperity and growth. Scenarios that rarely play out in the construction business for more than a few years in a row. Being in the construction business is a lot like living in an earthquake or hurricane zone. You don’t know when, but disaster will eventually occur.

Scenarios to Stress About

In 2012, banks used the following scenario to develop their analysis of strength under duress:

• Unemployment at 13%.
• 50% drop in equity prices.
• 21% decline in housing prices.

You can create your own worst-case scenario to see how formidable or feeble you may be given adverse circumstances, such as another mayor financial crises or a personal reversal:

• What happens if mortgage interest rates go through the roof and cool real-estate borrowing?
• What happens when lumber doubles in price due to heavy demand from a natural disaster, and you have some big projects under contract and lots of lumber to buy?
• What happens if you are suddenly unable to work due to illness or injury for six weeks or more?

Banks have the advantage of historical data to show how factors like unemployment will affect deposits and loan defaults. They compare this historical data to capital on hand and see if the institution can survive the crises.

You likely don’t have this kind of sophisticated data on hand, but you know some basic information that you can use to determine your ability to survive a crises and design a hedge.

To start, you must assemble a list of your monthly expenses:

• Your personal expenses.
• Your company overhead expenses, including office rent and utilities.
• Your skeleton crew of employees required to stay in business (maybe it’s just you).
• Any fixed costs, such as business loan or inventory payments that would be impossible to avoid without default.

With a list like this, you can determine your streamlined minimum needs in a crisis. You could say, well, I can sell the truck and the house, but these are not quick fixes, so you may find yourself in a world of trouble before you can reduce these expenses fast enough to match your shrinking revenue.

So determine the minimum amount you must have to avoid a collapse in your overall life and business operation. Let’s say it’s $15,000 monthly. You’re fine right now because you take in roughly $200,000 annually in gross profit. If you begin to break down the components of this profitability, you can see your exposure to negative market forces and personal calamities.

For example, if 50% of your income comes from selling new homes, then in a mortgage crisis, based on our hypothetical example, it’s possible your gross income would go down by that much, and suddenly you are facing a shortfall of over $6,500 a month. How will make that up?

Designing Your Stress Test

One way to look at your situation dispassionately is to use a spreadsheet. A simple, four-column spreadsheet showing your total (personal and company) income and expenses, the ratio between them and how many months of float you have before financial woes take hold (cash flow sufficiency):

In the illustration, although this contractor has a comfortable 25% spread between his personal income and expenses, once the complete financial package is tabulated, including the business, the margin is reduced to 15%. Were he to save all of the extra income for a year, there would be enough money in the bank to propel his personal life three months without a hiccup, but when the business is tabulated in, this cash breathing room is reduced to two months. This is how folks get into trouble quickly.

Of course, if the overflow cash were saved five years, the equation would be different and the two months become ten. So you must factor cash savings, if any, to make the equation more realistic. But don’t include home equity or other assets that you cannot quickly turn into cash. This is not a wealth evaluation; this is a crises tool.

What to Do Next?

Unless you’re swimming in cash, chances are the results of your analysis will be sobering, and the temptation is to close your eyes and hope for the best. But alternatives exist. We expect the good times to continue to roll for another year or two, so you can do three things:

1. You can reduce your expenses so the ratios improve. As you could see from our example, even an apparently adequate spread becomes woefully inadequate when income drops abruptly. A significant saving gets eaten up quickly.
2. You can save more, again, to build up a cash reserve—something that can be challenging without changing your lifestyle sometimes uncomfortably.
3. And you can develop a business plan less susceptible to economic ups and downs, such as handyman services, and a small, but efficient staff that can perform all company functions without you. In other words, a simple operation that does not require your manpower or expertise.

A combination of all three “hedges” suggested could put you in good shape to weather the next crises.

More on Building Business

Self-Taught MBA: Filling the Void of Cost Overruns – The most common source of cost overruns comes with items omitted. Learn to spot the voids, and develop a systematic approach to avoid them.

Self-Taught MBA: Strategic Alliances – Establishing strategic alliances can provide many of the benefits of partnerships without the contractual obligations.

Building Business – The foundation for your bottom line.