Surviving the ongoing global trade tensions
At this point, you’re likely aware that North American Free Trade Agreement (NAFTA) negotiations have stalled and a trade spat is brewing not only between the United States (US) and Canada, but also between the US and several other countries. Most media coverage has been layered with expected, nationwide ramifications - economic calculations or hypotheses - and that’s why we’re redirecting the light on how trade tariffs may lead individual Canadian businesses into distress. Those businesses who are proactively monitoring the situation with a long-term view may have an opportunity to position themselves to not only survive; but, thrive. But those turning a blind eye to the current landscape, or responding in a knee-jerk fashion, may find themselves worse off in the near future.
A brief history of recent events
The most recent trade tension began when the US government imposed 10-25% tariffs on Canadian steel and aluminum products. In a retaliatory move, Canada imposed tariffs on the same products from the US, in addition to a variety of other goods – from orange juice and condiments to motorboats and appliances. The US also imposed tariffs on certain Chinese imports, garnering retaliations by China. The US has continued to threaten more tariffs to both Canada and China. Canada has been swept into a game of tariff roulette, waiting to see which nation pulls the trigger next.
Import tariffs; what’s all the hype?
Historically Canada and the US have sought to reduce the levels of import tariffs between the two nations. As a result, cross-border relationships have thrived for decades leading to continued growth on both sides of the border.
Import tariffs are duties applied to imported goods – most commonly to make foreign goods more expensive and less attractive to domestic consumers. Over time, more consumers will favour domestic products made more competitive by the duties applied to foreign goods, keeping domestic industries and jobs alive and well. However, this mentality may lack some very important foresight.
Import tariffs drive up the price of foreign goods - and by extension - any final products manufactured domestically with foreign inputs. Businesses with foreign supply chains may be suddenly faced with higher costs and lower margins, teetering on a double-edged sword: pass on increased costs to customers via higher selling prices and they may worsen their market share position overnight; conversely, maintain selling prices to hold onto their precious market share and less margin may have them calling their bank for some more working capital cash this fall. One might think the golden ticket is replacing foreign suppliers with domestic suppliers today to avoid tariffs, but doing so may risk disrupting the entire supply chain for short-term savings. After the signing of a new NAFTA agreement, a switch-up of suppliers today may just end up costing businesses more in the long-run. Either way you slice it, trade tensions wars are pushing distressed decisions on Canadian businesses.
Distress will come in different areas of the income statement for different players; some businesses may experience increases in variable costs, pinching gross margin, whereas other capital intensive businesses may experience increases in capital costs, driving up fixed expenses. Some businesses may even experience both. In any case, the result is the same, a decrease in earnings and a need to increase sales simply to break even. Businesses with the narrowest of margins are least likely to weather the storm.
Even though supply chains will adapt to new tariffs over time and domestic economies of scale will become more efficient, it is unlikely that new supply chains will reach efficiency levels of optimized global supply chains (e.g., some countries are rich in natural resources while others have economic advantages such as a lower relative cost of labour). Less-efficient, more-expensive, domestically produced goods will eat up more hard-earned cash, so everyone is spending more on affected goods, leaving less cash for other consumption. As a result, tariffs may actually translate to decreases in GDP, leaving companies who may have been innocent bystanders bearing widespread recessionary distress.
In short, the politics driving trade tensions are simply about economic leverage, leaving us all caught in the crossfire.
Canadian businesses caught in the crossfire
The impact of cross-border tariffs are not limited to those products or industries which have been specifically targeted (i.e., steel producers). A well known example of the trickle-down effect of the current tariffs is Canadian auto manufacturers who are impacted by materially increased input costs due to steel and aluminum tariffs. Given the disparate list of goods targeted by the Canadian governments retaliatory tariffs, there are a host of Canadian businesses which are expected to feel the pinch either in top-line sales if the increased costs are passed along to consumers or in reduced margins if the costs are borne by the company.
Let’s take a closer look at one example of an individual product that escaped Canada’s import tariff list entirely - ice cream. With ice cream’s major ingredient being dairy spawned from domestically grown cattle, one may inadvertently assume there’d be no tariff ramifications to ice cream manufacturers. However, a better understanding of the ice cream business reveals otherwise:
- Tariffs on plastic coated paper may increase packaging costs;
- Tariffs on aluminum, steel, and manufacturing component costs may increase capital costs (e.g., equipment), the profitability of new investments, and the ability to adapt to changing consumer trends;
- Tariffs on herbicides, insecticides, and power equipment may increase farming costs, increasing the production cost of milk and cream;
- Tariffs on sugars, jams, and other ingredients may increase the cost of flavor ingredients added to ice cream bases.
Tariffs on a wide variety of inputs may have the potential to put pressure on manufacturers.
Canadian companies importing raw materials from the US are already seeing a jump in costs as a result of Canada’s retaliatory tariffs. Compounding this issue, there are many inputs coming from the US which themselves are subject to increased cost as a result of US import tariffs newly imposed on other nations such as China. Take motorboats as an example, some of which are assembled in the US:
- American motorboat manufacturers import motors from China, which are tariffed on entry into the US;
- Motorboats are assembled in the US;
- Motorboats are sold to a Canadian dealer subject to further tariffs on entry into Canada;
- Finally, motorboats are sold to end customers in Canada.
Now, it’s very easy to see how the impact of trade tariffs is compounded by international supply chains. Tariffs applied at each stage of production across international boundaries result in a multiplier effect that can substantially worsen the impact of global tariffs:
A game of capture the flag: protecting your fort to survive trade tensions
Economists are divided on how long the ongoing trade tensions may last, or when NAFTA will finally be renegotiated. In the interim, Canadian businesses need to understand the risks associated with rapidly escalating trade tensions and start making decisions that will protect their businesses long-term. What should Canadian businesses and their investors be doing in order to respond to the challenges coming their way?
Identify distress points early
Most businesses will be affected, in some way, by the evolving trade tactics at play. For businesses already facing difficulties, tariffs could even act as the final nail in their coffin. Others may have a critical supplier bearing the brunt of import tariffs, the demise of which would threaten the going concern of their own business. Early identification of critical distress points is often one of the determining factors in the survival of a challenged business. The earlier a company can identify a problem, the more options they have for shifting their course.
Early identification may include financial diligence on critical suppliers or the renegotiation of contract terms, all of which serve to protect cash flow and better prepare businesses to adapt and survive.
Optimize working capital to maintain liquidity
For companies with narrow margins, tariffs on key inputs could wipe out their profits – quickly causing distress. Companies should focus on maintaining and managing liquidity. A heightened awareness of working capital requirements is pivotal. Optimizing inventory levels, collecting on receivables in a timely manner and taking advantage of available supplier discounts will allow proactive companies to shed unnecessary weight, hunker down, and ride out the storm.
Optimizing working capital in combination with access to the right lending solution, whether it be a margined operating line of credit or an asset backed loan, can unleash liquidity.
With escalating economic and political uncertainty, the risk that trade feuds will get more and more gruesome is considerably real. If you have not yet been affected, it may only be a matter of time until things will get worse. If they do, those businesses who are able to adapt most quickly will be better positioned to succeed competitors. For some businesses, this may mean quick access to cash to fulfill contracts and keep the bottom line in the black. For other businesses, quick access to cash may present an opportunity to grow market share while competitors are stifling.
Arranging stand-by financing in advance prepares you to absorb the bumps and bruises, and gives you the upperhand to diffuse adverse situations.
Make holistic supply chain decisions
Many companies will likely make knee jerk reactions in an attempt to thwart off cost increases.
Making sudden supply chain changes can have significant ramifications for companies, increasing costs and risks well in excess of those caused by new tariffs. Companies must consider the longer term effects of changing suppliers such as the quality of inputs, ability to source significant quantities, and the timeliness of deliveries. While some companies may find short-term savings by switching suppliers, the long-term impacts of these decisions may ultimately do more harm than good.
Taking the time to thoroughly consider long-term costs and benefits of decisions can save companies more in the long-run.
Restructuring and reorganization
Sometimes, even if distress points are identified early, working capital is tightly controlled, the right supply chain decisions are made, and access to capital is sufficiently explored, a reorganization of the business or restructuring of corporate entities may be necessary.
If tariffs have done irrevocable harm to your business and you’re in dire need of relief, you still have options. Perhaps it’s time for the divestiture of a division you’ve overlooked until now or maybe it’s in your best interest to consider filing for some type of creditor protection. Either way, meandering through these processes without an understanding of the ongoing dispute at play may be the final straw.
Plan to thrive, not just survive
Recent tariffs may simply be the beginning of a broader trade dispute; there are no signs that trade tensions are cooling off anytime soon.
While surviving may be the most immediate concern for some businesses, Canadian companies should also look at finding new ways to thrive in the long-term. Identifying distress early, optimizing liquidity, exploring access to stand-by capital, making long-term supply chain decisions, and considering restructuring alternatives will position you best to emerge victoriously.