Large and small businesses face declines in sales and profits during a recession. Economic downturns affect credit access, slow collections, and spur business bankruptcies.
During an economic downturn, a small consulting firm might experience cash flow issues as clients delay payment. A Fortune 500 corporation may be forced to cut jobs and negotiate better terms from suppliers.
Key Takeaways
- Recessions are significant, widespread, and sustained contractions of economic activity marked by declines in the gross domestic product (GDP).
- All business sectors typically face declines in sales and profits in a recession.
- Cutting costs may include layoffs and cuts in capital spending, marketing, and research.
What Is a Recession?
The National Bureau of Economic Research defines a recession as "a significant decline in economic activity that is spread across the economy and lasts more than a few months." Recession is commonly noted by a decline in the gross domestic product (GDP) for two consecutive quarters.
Recessions cause job losses and a contraction in economic output as consumer spending and business investment slump. The NBER uses indicators like nonfarm payrolls,industrial production, andretail sales to track recessionary periods.
Financial Challenges
- Slumping Sales: During an economic contraction aggregate demand declines, translating into a drop in sales for most businesses. Cyclical industries including manufacturing, real estate, and tourism tend to experience particularly sharp declines. Companies with high fixed costs may face a disproportionate hit to the bottom line as revenue declines.
- High Inventory: Manufacturers may face bloated inventories, forcing them to slow output until demand recovers.
- Return on Investment: The souring of consumer demand lowers the expected returns on investment for advertising and marketing spending, prompting cuts.
- Tighter Credit: Faced with a downturn of uncertain severity and duration, lenders become selective of the risks they are willing to underwrite.
- Unpaid Invoices: 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 pay or default.
- Bankruptcy: Businesses unable to refinance may face fixed debt service costs that must be met even as sales and profits slump. Business bankruptcies may increase.
- Layoffs: Businesses large and small may undertake layoffs to cut costs, especially if they need fewer workers to meet the reduced demand. Productivity per employee may increase, but morale may suffer as workloads increase while pay gains slow or stop amid the risk of further layoffs.
Many 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.
Impacts on Small Businesses
U.S. small businesses have impressive numbers in the aggregate. Defined expansively as those with fewer than 500 employees, they consistently account for around 44% of the U.S. GDP. In 2023, nearly 62 million Americans were employed by small businesses. These companies tend to fare worse than large ones in a recession because they're less able to withstand a drop in revenue amid mounting economic uncertainty.
Accessing capital can be a challenge.Startups and businesses with four employees or less commonly use personal savings to finance operations. They may rely on credit cards, community banks, and credit unions and compete with larger businesses for corporate capital at larger banks. This lack of scale leaves many small businesses with less financial cushion, market power, and leverage to weather the tough times a recession brings.
Lenders may be less enthused about lending to a business without significant cash reserves and capital assets that can serve as collateral during heightened uncertainty. Unlike publicly listed companies, small businesses typically can't raise funds by selling stock in a secondary offering or issuing bonds. As a result, small businesses are particularly vulnerable to spikes of Chapter 11 bankruptcies.
How Large Companies Are Affected
Large companies aren't immune to recessions. During the economic downturn in 2020 associated with the COVID-19 pandemic, 244 sought bankruptcy protection, the most since 2009; energy, retail, and consumer services were the hardest hit sectors.
When revenue and profit decline 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.
They may reduce hiring, impose a hiring freeze, 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. 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.
What Is Sticky Wage Theory?
Wages are sticky, meaning workers are reluctant to accept pay cuts 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.
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.
How Can Businesses Prepare for Recessionary Periods?
Companies can build a strong balance sheet or diversify cash flows to boost resilience to market shocks. Business units and product teams should be set up to respond quickly and effectively to changes due to recessionary periods.
The Bottom Line
Recessions force 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.
