Defining Recession

When it comes to recessions, sometimes the best definitions are the light-hearted ones. "If your neighbor gets laid off, it's a recession. If you get laid off, it's a depression," as one economist jokingly put it. However, economists officially define a recession as two consecutive quarters of negative growth in the gross domestic product (GDP). According to the National Bureau of Economic Research, the hallmark of a recession is a "significant decline in economic activity spread across the economy, lasting more than a few months."

Both definitions are accurate because they indicate the same economic results: a loss of jobs, a decline in real income, a slowdown in industrial production and manufacturing, and a slump in consumer spending, which drives more than two-thirds of the U.S. economy.

In this article, we break down how economic downturns can impact small and large businesses — and what you, as an investor, can do to prepare. While some businesses may only see moderate losses in a mild recession, as declines drag on, companies small and large will be tightening their belts.

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How a Recession Affects a Business

Recession Impacts on Large Business

Let's say an unnamed Fortune 1000 manufacturer is suffering from the effects of a recession. What happens to this firm will likely happen to other big businesses as the recession runs its course.

As sales revenues and profits decline, the manufacturer will cut back on hiring new employees, or freeze hiring entirely. In an effort to cut costs and improve the bottom line, the manufacturer may stop buying new equipment, curtail research and development, and stop new product rollouts (a factor in the growth of revenue and market share). Expenditures for marketing and advertising may also be reduced. These cost-cutting efforts will impact other businesses, both big and small, which provide the goods and services used by the big manufacturer.

Falling Stocks and Slumping Dividends

As declining revenues show up on its quarterly earnings report, the manufacturer's stock price may decline. Dividends may also slump, or disappear entirely. Company shareholders may become upset and may, along with the board of directors, call for the appointment of new company leadership. The manufacturer's advertising agency may be dumped and a new agency hired. The internal advertising and marketing departments may also face a personnel shakeup.

When the manufacturer's stock falls and the dividends decline or stop, institutional investors who hold that stock may sell and reinvest the proceeds into better-performing stocks. This will further depress the company's stock price. The sell-off and business decline will also impact employer contributions to profit-sharing plans or 401(k) plans if the company has such programs in place.

Credit Impairment and Bankruptcy

A recession will also dampen a company's accounts receivable (AR). Customers who owe the company money may make payments slower, later, or not at all. Then, with reduced revenues, the affected company may be forced to pay its own bills slower, later, or in smaller increments than their original credit agreement required. Making late or delinquent payments will reduce the valuation of a corporation's debt, bonds, and its ability to obtain financing. The company's ability to service its debt (pay interest on the money it has borrowed) may also be impaired, resulting in defaults on bonds and other debt and further damaging the firm's credit rating.

On the other end of a recession, a company's debt may need to be restructured or refinanced, meaning new terms will have to be agreed upon by creditors. If the company's debts cannot be serviced and cannot be repaid as agreed upon in the lending contract, then bankruptcy may ensue. The company will then be protected from its creditors as it undergoes reorganization, or it may go out of business completely.

Employee Lay-offs and Benefit Reductions

The business may cut employees, and more work will have to be done by fewer people. Productivity per employee may increase, but morale may suffer as hours become longer, work becomes harder, wage increases are stopped, and fear of further layoffs persists.

As the recession increases in severity and length, management and labor may meet and agree to mutual concessions, both to save the company and to save jobs. The concessions may include wage reductions and reduced benefits. If the company is a manufacturer, it may be forced to close plants and discontinue poorly performing brands. Automobile manufacturers, for example, have done this in previous recessions.

Cuts to Quality of Goods and Services

Secondary aspects of the goods and services produced by the recession-impacted manufacturer may also suffer. In an attempt to further cut costs to improve its bottom line, the company may compromise the quality, and thus the desirability, of its products. This may manifest itself in a variety of ways and is a common reaction of many big businesses in a steep recession.

Airlines, for example, may lower maintenance standards. They may install more seats per plane, further cramping the already squeezed-in passenger. Routes to marginally profitable or money-losing destinations may be cut, inconveniencing customers and damaging the economies of the canceled destinations.

Giant food purveyors may offer less product for the same price in the same size package. The quality of food being produced may also be cut, compromising flavor and driving away cost-conscious consumers with little brand loyalty who will likely notice the change.

Reduced Consumer Access

As firms impacted by the recession spend less money on advertising and marketing, big advertising agencies which bill millions of dollars per year will feel the squeeze. In turn, the decline in advertising expenditures will whittle away at the bottom lines of giant media companies in every division, be it print, broadcast, or online. As the effects of a recession ripple through the economy, consumer confidence declines, perpetuating the recession as consumer spending drops.

Recession Impacts on Small Businesses

Small, private businesses with annual sales substantially less than the Fortune 1000 actually perform fairly similarly to large businesses during a recession. Without major cash reserves and large capital assets as collateral, however, and with more difficulty securing additional financing in trying economic times, smaller businesses may have a harder time surviving a recession. Bankruptcies among smaller businesses typically occur at a higher rate than among larger firms.

The bankruptcy or dissolution of a small business that serves a community — a franchised convenience store, for example — can create hardships not only for the small business owners but also for residents of the neighborhood. In the wake of such bankruptcies or dissolutions, the entrepreneurial spirit which inspired someone to go into such a business may take a hit, discouraging, at least for a while, any risky business ventures. Too many bankruptcies may also discourage banks, venture capitalists, and other lenders from making loans for startups until the economy turns around.

The Bottom Line

Recessions come and go and some are more severe and last longer than others. But history shows that recessions invariably end, and when they do, a period of economic recovery follows.