One of globalization’s most sweeping effects has been to transform closed, government-controlled financial systems into free markets open to foreign investors. Over the past two decades, surging capital flows have reduced funding costs for corporations and enabled investors to reap higher risk-adjusted returns. But unfettered capital markets have a downside: increasingly frequent economic breakdowns, particularly in emerging economies. More than 65 serious financial crises have erupted over the past ten years—almost one and a half times the number recorded during the 1980s.¹

Last year alone, Argentina suffered a bank shutdown and a severe devaluation when it defaulted on its government debt, and a long-smoldering crisis flared in Turkey after one of the country’s largest banks went under, causing confidence to crumble. Industrialized countries are also vulnerable, as Sweden found in 1992, when a real-estate-market bubble burst, plunging banks into the red and causing the value of the krona to plummet.

Yet no matter how real the threat of national financial meltdown might be, and no matter how devastating the consequences, many companies seem disinclined to safeguard themselves—even though, in our experience of dozens of such events over the past 15 years, managers can take many precautions. Obvious measures include monitoring potential warning indicators, maximizing cash, and restructuring debt. To be more thorough still, companies can minimize their key operational risks, run crisis scenario analyses, and devise explicit plans for crisis management.

The better prepared a company may be, the more likely it is to survive a crisis. It might even position itself to prosper from the chaos. Consider the case of the Ayala Group, one of the oldest conglomerates in the Philippines. Ayala has traditionally been more fiscally cautious than its peers, keeping larger amounts of cash on hand and holding less debt than might seem efficient (exhibit). But this prudence has enabled the company to withstand numerous difficulties in its 165 years. During the 1997 crisis that swept through Asia, for example, while competitors were putting the brakes on their capital expenditures, Ayala went on aggressively building out the country’s first digital wireless network on the Global System for Mobile Communication (GSM) standard. The Ayala subsidiary Globe Telecom is now the top wireless company in the Philippines. In the banking industry, Ayala acquired one of its major competitors (which was in distress), thereby boosting its own Bank of the Philippine Islands from the country’s fifth- to second-largest bank in terms of assets.

Readiness has a price, however: management not only must constantly be ready to engage in battle but also must moderate the usually intense focus on quarter-to-quarter financial results. In strong economic times, analysts have chided the Ayala Group for its conservative balance sheet. But in most cases, careful planning greatly improves the odds of surviving financial crises, though the worst of them—those that spark political furors, such as the 1998 crisis in Indonesia and the 2001–02 crisis in Argentina—can bring down the best-prepared companies.

See the warning signs

Amid the instantaneous and fickle movements of information and money in borderless capital markets, corporate executives can rely on no one but themselves to spot the next crisis welling up. Stanley Fischer, former first deputy managing director at the International Monetary Fund, once commented wryly that "The IMF has [privately] predicted 15 of the last 6 crises. If we went out and started predicting [publicly], we would bring on many crises."² Indeed, the problem of self-fulfilling prophecies puts severe constraints on all public watchdogs, and managers thus cannot depend on the IMF or ratings agencies to sound the alarm.

Macroeconomic conditions do matter, but the macroeconomic signs are usually the last to start flashing red before a crisis breaks

The good news, though, is that warning signs can be spotted well in advance if managers take the time to look. Most observers focus on macroeconomic variables such as exchange rates and fiscal deficits. Macroeconomic conditions certainly matter—smart managers regularly review the country reports put out by bank analysts and well-informed journals—but these signs are usually the last to flash red before a crisis breaks. It is in the real economy and the banking system, where the roots of crises develop, that the first indications of trouble to come can be seen.³

Indeed, warnings abound: companies fail to earn their cost of capital or to maintain enough cash flow to cover interest payments comfortably, for example, while commercial banks go on lending sprees, often doling out funds to increasingly unstable corporations (see sidebar, "Signs of crisis"). Ultimately, these problems show up in the banks’ profitability and nonperforming-loan portfolios. Foreign lenders may add to the credit binge with short-term foreign-currency loans.⁴ Asset price bubbles, often in real estate or the stock market, inflate collateral values and put banks at risk. When several of these indicators start heading in the wrong direction at once, trouble is sure to be brewing.

Symptoms of Argentina’s crisis, for example, were visible long before it erupted in December 2001. The economy of Argentina had been shrinking for the past four years, and its companies’ return on invested capital for some time had been lower than the cost of capital. Depositors had been moving funds offshore for more than a year and stepped up the pace sharply in the six months before the crisis erupted. Meanwhile, Argentina’s fiscal deficit had ballooned, placing the country on an unsustainable borrowing binge. The writing was on the wall.

Conserve cash and restructure debt

When the storm breaks, revenue streams and credit lines dry up and interest rates skyrocket. After Brazil’s sharp devaluation in 1998, interest rates soared to 65 percent and stayed there for more than three months. In Argentina, interest rates rose to 74 percent in November 2001—just before the government froze deposits and banks stopped lending money altogether. Under such circumstances, companies that lack adequate cash flows or bear a heavy burden of indebtedness soon develop liquidity problems and often descend rapidly into insolvency.

To protect against this kind of shock, companies must put their balance sheets and income statements in order as early as they can, before it becomes impossible to find creditors and revamp cash flows. Two important indicators of a company’s ability to withstand a storm are the amount of free cash flow⁵ it generates and its interest coverage ratio, or ICR (the ratio of cash flow to debt payments over a specified period). Our experience of working with companies in emerging markets suggests that many such organizations don’t fully understand their cash flows and are liable to make the fundamental mistake of believing that profits equal cash flow. It is also not uncommon for companies to have an ICR of less than 1, meaning that they stay afloat only by using new loans to repay old ones. In South Korea in 1999—well after the chaos of the region’s 1997 crisis had subsided—40 percent of listed companies were in this acutely unstable situation, and a further 20 percent were only slightly less at risk. Fortunately, the situation in South Korea has improved significantly over the past three years.

Companies blessed with more farsighted management will maximize their cash flows by divesting cash-consuming business units and optimizing their working capital. Aurrerá, a Mexican supermarket chain, honed its cash-management skills after the country’s 1982 economic breakdown. It negotiated special terms with suppliers that granted it 60 to 90 days on accounts payable and shortened accounts receivable, thereby producing a negative working-capital position. This spread enabled Aurrerá to finance its own growth during the remainder of the 1980s, when the rest of the Mexican economy stagnated, and into the 1990s. In 1996 Wal-Mart acquired the chain in a deal that was highly lucrative for its private owners.

Samsung Corporation, a business within the Samsung Group, also learned a valuable debt lesson during hard times. Just before South Korea’s economy nose-dived in 1997, the company had almost two-thirds of its $2.1 billion total debt due for repayment in less than a year. About 20 percent was denominated in foreign currencies. When corporate bond rates leapt from 12.6 percent at the beginning of November 1997 to more than 30 percent by the end of the year, Samsung Corporation’s debt payments took off too. The company survived and within two years had brought the level of its short-term loans down to less than 20 percent of its total debt.

Of course, reducing debt levels (to no more than 50 percent of equity, for example) and lengthening loan maturities will increase the cost of borrowing. But the premium can be regarded as insurance for stable funding through thick and thin. Companies should also hedge their currency risk on foreign loans even if the exchange rates of their countries are supposed to be fixed; in every crisis over the past decade, fixed or managed exchange rates collapsed. But hedging currency risk is expensive (if not impossible) when currency forwards and derivatives markets are lacking. In this case, companies can, for example, establish a natural currency hedge or try to earn dollar-based revenues to offset dollar-based interest payments. Companies that lack a natural hedge or access to currency forwards shouldn’t borrow foreign currencies, no matter how tempting it may be to do so, and may even want to prepay foreign-currency liabilities. Currency depreciation may average more than 100 percent during the first two quarters of a crisis.

Finally, chief financial officers can diversify and strengthen their funding sources. While times are good, backup lines of credit must be established. When they are in place, companies—even large conglomerates with as many as 100 different lending sources—should continue to monitor the health of each lender. To maintain a solid funding base, Doosan, one of the oldest conglomerates in South Korea, rates the financial health of each of its lenders by examining their quarterly reports. Any lenders that show signs of weakness are identified early and replaced by stronger banks.

Minimize operational risks

Contingency planning should extend to suppliers, wholesalers, and retailers as well as transportation. In a crisis, domestic suppliers could file for bankruptcy or stop shipments to conserve cash, while foreign suppliers might worry about a buyer’s creditworthiness or find themselves hamstrung by interruptions in the international payments system. Sudden consumer demand shifts that occur when people lose their jobs and savings could damage wholesalers and retailers, and liquidity problems among shippers could make transportation grind to a halt.

Understanding these risks and planning for them can make the difference between surviving a crisis and succumbing to it. In 1997, one South Korean automaker saw many of its parts suppliers go under. Without backup suppliers, it couldn’t increase production for export when the won was devalued. While foreign distributors begged for more cars to sell, production lines were idle back at home for lack of critical parts. The company weathered the storm but never fully recovered its market position and was eventually acquired by another domestic automaker.

The message for managers is that they should identify their most important suppliers before trouble starts. For specialized, noncommodity inputs, companies would be well-advised to establish reserve suppliers and to keep an eye on the financial situation of each. For more general inputs, it makes sense to diversify a supply base a bit more than usual from the outset. Increased purchasing costs and some management inefficiencies are a price worth paying to ensure continued operation at all times.

A similarly watchful eye should be kept on the profitability and financial stability of wholesalers and retailers. During Russia’s 1998 financial crash, Roust, a large consumer goods distribution company, was particularly effective at limiting losses, because it kept tabs on its distributors’ health. Within days, the company retrieved 90 percent of its stock of alcoholic beverages from wholesalers. Although Roust suffered losses on inventory, the company then resupplied goods in limited quantities on a prepaid basis to its most solvent distributors, thereby preempting defaults on accounts receivable.

Furthermore, in the midst of chaos, transportation can’t be taken for granted. For one thing, companies can find their just-in-time supply chains disrupted. In Mexico in 1982, for instance, the cash-distribution logistics chain of Banamex, a leading bank, became so strained that executives feared that branches would run out of cash, sparking a bank run. The ingenious response was to hire off-duty ambulances to help the company’s armored cars distribute cash, thus averting chaos. Other banks were less successful.

Conduct scenario planning

Minimizing financial and operational risks can vastly improve a company’s chances of survival. The use of scenario analyses and contingency planning can put a company on an even higher level of alertness. Thus many consumer goods companies now routinely study Johnson & Johnson’s classic, speedy, and successful response to the 1982 Tylenol crisis, in which seven people died after swallowing tablets laced with cyanide. Anticipation and familiarity with crisis situations—even simulated ones—pay off when the real thing erupts.

Scenario planning typically centers on a financial model that shows how a company’s cash flow and balance sheet change in response to key variables. At the very least, changes in the following variables should be tested: demand (both volume and price), supply chain disruptions, external funding conditions (including interest rates, stock prices, and a liquidity crunch), macroeconomic conditions (exchange rates), and the competitive landscape (the health of competitors or the possible arrival of global ones). For each variable, companies must consider a broad—and perhaps previously unthinkable—range of outcomes. In the crises we studied, we have seen exchange rates plunge by 50 percent in weeks, interest rates triple, lines of credit and new loans dry up completely, and demand for consumer durable goods fall by up to 70 percent almost overnight.

Simply conducting such an exercise helps to prepare management mentally for an actual crisis. But the real value of the exercise lies in following it up with contingency planning. Which assets could a company most easily divest to raise cash, for example? Which plants or offices, if closed, would cut costs most sharply or preserve the largest amount of cash? Which products or services are least profitable and could be jettisoned? Conversely, what critical business lines and customer relationships must be preserved at any cost?

Again, earlier is better. It takes time to compile data and run analyses, but in a crisis, decisions must be made within hours or days, not weeks. By putting contingency plans in place, senior executives will be able to delegate responsibility for specific actions quickly, freeing up their own time to think about strategy; to communicate with customers, suppliers, and creditors; and to monitor operations.

Prepare crisis leadership

Most companies fail to act decisively, though the initial days of an emergency are critical. The postcrisis landscape is littered with the corpses of survival programs that weren’t implemented in time. Almost as important as what to do is how to do it. Planning specific management responses ahead of time can prevent crippling paralysis and delays.

The first step is to plan who does what when a crisis erupts. For a large conglomerate with many business units, it would not be unreasonable for the CFO and CEO to spend all of their time monitoring the situation and making decisions in real time. Fifty or more junior people might be needed to do the legwork. Knowing in advance who is going to serve on the crisis-management team and how responsibilities will be divided can save time and enable a company to stop the bleeding quickly.

One approach that we have found useful is the creation of specialized teams to lead key activities. A cash team might measure and report on the company’s cash flow every day and maximize working capital. A funding team would monitor upcoming debt payments and the health of creditors. And a divesture team would sell noncore assets to raise cash. These teams would typically report to the CFO every day and update the CEO at least several times a week.

For the CEO, a crucial task in the first few days is to lead a communications team that maintains the trust of key shareholders, suppliers, and customers by reaching out to them frequently and straightforwardly. A company will have to issue broad announcements about the status of its business and key assets, and top executives will probably have to supply a few crucial investors, creditors, suppliers, and customers with more (or more detailed) information. Contradictions, obfuscations, and partial disclosures are almost always judged negatively and can compound the crisis.

National financial crises are becoming a permanent fixture of the global economic landscape. Companies that ignore this truth and carry on with business as usual are likely to be part of the wreckage left after the event. Those that plan for any contingency raise their chances of survival and might even turn adversity into advantage.