Far better to recover the capital and invest in the more specialised categories where there is still some scope to add value to the core functions of instant availability, breaking bulk and providing credit. Even these categories may not sustain the distribution dimension of Computacenter’s business, though they are a more natural fit with its corporate reselling activities.
It may seem rather hackneyed these days, but all distributors have to make the strategic choice between:
Get big
Get niche
Get out
Any other strategy is simply deferring the problem and will soak up more capital and cashflow the longer the decision is deferred.
The key question for Comptacenter is which play is it making in the storage and server categories? And then will the profits generated cover the cost of capital invested in this part of the business?
It was significant that the PC and printer distribution business generated £70m of sales, but no profits (according to CRN). This suggests the decision has been made rather late as even at optimum working capital management ratios, Computacenter will have had around £7m of capital tied up in PC and printer distribution. Not many businesses can afford to have that sort of capital tied up generating no return. Certainly not one that increased its interim dividend only last October.
Computacenter will not be the only player to move out of the distribution business, in part or in whole. There will be further consolidation, especially at the broadline level and even the specialists will find superior margins cannot compensate for the fall in volumes we are likely to see in 2009.
Right now IT resellers are going bust at the rate of 15 a week in the UK and similar patterns are emerging across Europe and the US. Some commentators are talking in terms of 1 in 6 resellers being in trouble and many of those that are clinging on are relying on overdrafts as a permanent source of finance
Credit insurers are withdrawing or reducing cover for the major distributors limiting their ability to provide extended credit to their reseller customers for those all-important big deals with large/medium corporates.
No matter who you talk to, there is a consensus that the channel is going to undergo another shakeout and there will be many losers and fewer winners.
So what is a vendor to do to protect its market access? And what are account mangers to do to ensure the shakeout doesn’t leave them falling short of sales targets?
Here is a five point checklist to help vendors and their account managers to navigate successfully through the worst of the recession:
Get close and personal – In tough times, the business changes long before the effects show up in any management information so you need to be talking to the management to understand how close they are to the situation: Do they have figures at their finger tips? Do they know the weekly cash “burn rate”? Do they know what sales they need to be able to make the payroll? If you have key resellers that are struggling, you need to be in weekly or even daily touch.
Talk Pipeline – Two things happen to the pipeline in times of low confidence: deals get cancelled and deals slip backwards. In many ways it is the deals that slip backwards that are the bigger contibutors to downfall. Management clings to the hope that the deal will come in, so they don’t take action quickly enough. The pipeline needs to be mapped over the next few months in terms of the revenue they will bring in each month. Overheads burn up cash by month, so income needs to be projected in the same way. Be very wary of resellers that talk in terms of a pipeline of total £100ks or £ms. That’s not relevant. What matters is how the pipeline looks for income contribution next month and the month after that. Then see what it looks like if the biggest deal slips back one month…and how long will the cash hold out? As a vendor, you need to make sure that you are doing everything to ensure that when deal lands, the income can flow as fast as possible. It’s one thing to see business slide backwards through on the demand side…but unforgivable if the causes are on the supply side.
Deliver tough love – Most business fail just as they start taking the tough medicine they should have swallowed months before. By the time they finally realise just how dire the situation has become and tinkering won’t cut it, there isn’t time to do the right thing. So as someone who knows the business but is on the outside looking in, you can help force your partner’s management team to face reality and take decisive action….early. Become an objective and dispassionate advisor and you could make the difference to some of your key partners.
Be a Marriage Broker - Even if you follow the first three guidelines, it’s almost impossible to predict the winners and losers (and size of partner is no guide in these extraordinary fast-changing markets). So do the next best thing and help bring complementary partners together, even if only to deliver a single deal or project, to increase their chances of survival. Both partners will remember and appreciate the support, winning loyalty and greater management confidence.
Don’t do things by halves – Do your risk assessment of each partner and then act with commitment. If you think they are good for the next few months, then give them the support they need. Don’t strangle them with reduced credit or impose self-protective measures. These will only change the risks and bring about the very situation you were trying to avoid. Equally if you have worries, then don’t offer partial support. Pull credit, cut off supply, withdraw account management. Just take the time to explain what caused you concern as you go and tell your former partner what has to happen before they should get back in touch. You can then focus your attention on those partners you think are worth backing without distraction. It’s tough, but essential. And your hard action could just force the management of the weak partner to take decisive action and save themselves.
Finally manage your own expectations. You will not get every judgement right. No one does. Even venture capitalists, who make a living on these kind of judgements only expect to get 50% right at best.
If you want more help on understanding the economics of channel business and specific types of channel partner, you can find it in the book: Distribution Channels published by Kogan Page on ISBN 978-0-7494-5256-8.
A recent study by OC&C in the UK has shown the impact of the growth on on-line sales on category margins. For those retailers whose sales are dominated by these categories, profits (EBIT) are considerably weaker.
The categories which have seen margins most affected by the high proportion of on-line sales are:
Music, video and gaming (30% of sales are on-line, 2% profit margin)
Electricals (15%, 2%)
Books and stationery (14%, 2.4%)
Grocery is perhaps the exception (4%, 3%), affected more by intense concentration than by the proportion of on-line sales.
At the other end of the spectrum are categories which include:
Clothing, footwear and accessories (4% on-line, 8.8% margin)
Opticians, pharmacies, health & beauty (2%, 7.1%)
Both of these categories are notable for their connection to fashions, and thus the importance of browsing, touch and feel, trial, which can be experienced only in traditional store formats.
What should be of concern to retailers in the “high on-line” categories is that these margins were pre-recession,. The study was based on published financial accounts and these will be anything up to 18 months old. It is quite surprising just how low these operating margins are – which effectively means how close to breakeven the majority of retailers are.
The recession is showing up as a significant fall in sales. Year on year comparisons are around minus 8% in the critical pre Christmas/Holidays trading season. This will have pushed many retailers into losses immediately, and of a scale that cannot be met with trimming of overheads. Structural changes and consolidation will take place amongst retailers focused on the “high on-line” categories. Already Circuit City (Electricals) has filed for bankruptcy and Woolworths (Mixed goods) and MFI (DIY, home & gardening) have been put into receivership.
Retailers operating in the “high on-line” categories have been forced to embrace the on-line selling motion applying the same prices across all their channels and actively encouraging customers to flit between on-line and off-line (PCWorld, John Lewis, Tesco). Better to cannibalise your own sales than be cannibalised by others. They may find they need to reduce the floor & shelf space allocated to these categories, and provide on-line kiosks or catalogues in store to offer the full range and selection customers look for. They will also need to sharpen their customer service skills and extend their array of services that on-line propositions cannot match.
Bad news for suppliers who rely on retailers
Vendors with multiple routes to market have long found that retail was an expensive channel, but now must worry that it is also a highly vulnerable one as well. The irony is that in many categories, the vendors have been accelerating the growth of direct on-line sales that puts their retail partners in jeopardy.
The worry of potential demise will cause many vendors to limit their exposure to retailers, cutting credit limits and strangling allocations. This in itself will weaken the retail proposition to consumers, who are becoming increasingly used to finding the best array of range and assortment on-line rather than in-store.
Account managers or account teams looking after retailers need to ensure they are close to the trading numbers of the categories they operate in and ensure they are balancing sales and marketing activities with risk assessment and exposure control. Marketing managers need to look at all their programs and ensure that they are not exacerbating the situation by distorting business models or loading up accounts with excessive inventories.
The Retail channel is far more vulnerable to the recession than many seasoned commentators thought – and those categories with a high proportion of on-line sales are under real threat.
As predicted in earlier posts, distributors are now using a new weapon in their fight to retain reseller accounts – Smart Credit. Vendors should take note and ensure their programs can underpin this strategy, as smart credit will become a critical success factor.
This week CRN reported that Bell Micro will be granting more credit to the VARs that demonstrate greater loyalty:
“Bell informed 600 resellers with credit lines between £5,000 and £50,000 that credit terms would be extended from 30 to 45 days if they paid via direct debit. Additionally, VARs using upwards of 30 per cent of their credit lines will have them increased by 25 to 100 per cent.”
Bell is smart to use its credit in this way to reward loyaty and encourage resellers to switch their orders to Bell. Once hooked on extended credit, many will find it difficult to switch back to the other broadliners who have adopted much cruder tactics.
How should vendors react?
The key issue for vendors is market access. If their distributors are able to direct scarce credit capacity at the parts of the channel that reach targeted end users, then vendors should be partnering in the tactic. This could include:
Extending credit in line with growth in volume of targeted resellers
Co-funding credit insurance against the extended credit terms to targeted resellers
Co-funding the financing costs of extended credit to targeted resellers
Why aren’t all the distributors using smart credit?
Critics of this approach argue that it slows down the cash-to-cash cyle :
Nick Tiltman, credit director at C2000, said he was “bemused” by the accusations – Quoted in CRN:
“Extended terms slow up cash in the channel and there is enough of that happening anyway,” he said. “Why would you want to exacerbate that? If resellers are not using the credit lines that they already have, I cannot understand Bell’s reasons for doing this.”
The answer is a little bit of a chicken and egg. End customers need the credit to enable them to commit to making a purchase. Resellers need the credit themselves to be able to offer it. So no credit available means lower demand, and little use of existing facilities. Bell’s scheme means resellers can offer extended credit to their customers with confidence and make the sale.
It’s become very fashionable for politicians to claim their measures to respond to the current economic crisis are the “right” ones as in, “this is the right thing to do” (Gordon Brown, Barack Obama, Nicolas Sarkozy, et al).
For distributors and vendors facing dramatic falls in sales volumes and huge strains on their dwindling credit capacity, using the “right” measures could make a real difference in getting through the crisis. By measures we mean the financial ratios used to manage the business and support decision making.Too many distributors and vendors focus their attention on the wrong measures that in the good times, simply wasted opportunities and capital. However, in the current climate, failing to learn from these mistakes could mean failure of the business for the distributor and the loss of market access for the vendor. And don’t think size gives protection – CHS, Europe’s largest distributor went bust spectacularly, owing hundreds of millions of dollars to the vendors who had seen it as a healthy alternative to Tech Data and Ingram Micro.
The complex subject of choosing the right measures can be boiled down to four, and in each case you will usually find there is a wrong measure that is more frequently used instead:
Aspect of Business performance
Wrong measure
Right measure
Profitability
Gross margin
Contribution margin
Productivity
Return on sales
Return on capital
Sustainability
Net Profit
Economic Profit
Survival
Growth
Cash flow
If you think that anyone is too sophisticated to be using the wrong measures, then take a look at their recent annual reports and press releases and look at how they describe their performance and the rational for their strategic decisions…almost every major distributor and vendor has selected terms exclusively from the middle column.
How can Gross margins be a wrong measure? Easy, they are just too simplistic. Distributors need to take into account all the elements of the vendor relationship (brand marketing support, supply chain integration, soft funds, funded heads, and warranty burden, etc) as well the specific aspects of the product (sales rates, returns rates, pre and post sales support requirements, etc). These are all captured in a well-structured contribution margin measure.
Return on capital is for the shareholders isn’t it? Yes, and who is about the only source of capital in town these days? (Clue: it’s not the banks). And here’s the issue; to deliver an acceptable return on capital, distributors and their vendors have to concentrate on making their capital work as hard as possible. The way to do this is to make capital turn over faster, so spinning the inventory, controlling credit given to customers and securing more credit from vendors. There are a whole raft of measures that are return on capital measures that can be applied within product management, vendor management and customer management roles. The better distributors are using measures like Return on Invested Capital, Gross margin Return on Inventory Investment, both to measure their business and to incentivise their managers.
What’s Economic Profit (sounds complicated)? The concept of economic profit is to compare the profit earned from operations to the cost of the capital that was needed to generate that profit. So is $100m operating profit a sustainable outcome? Well, only if the cost of the capital used was less than $100m. Otherwise, over time the sources of capital will dry up. A business that has operating profit > cost of capital can be said to be creating value; and one with operating profit < cost of capital is said to be destroying value. Which one would you trust with your $100m? Exactly. That wasn’t too complicated was it?
If you don’t grow, you are going backwards…Maybe, but if you don’t have cash, you aren’t going anywhere. Survival means being able to balance the flows of cash in and out of the business. And that means having a very clear view of these cash flows over the next few weeks and months. With everyone struggling to stretch credit limits, it can be very sobering to add a few days to the assumptions you make about when you will get paid. Businesses can run out cash within days if the cash to cash cycle gets stretched at both ends (customers and suppliers). Divide the cash balance into the sales turnover to see how many days’ trading your cash reserves represent. Even twenty days can disappear quickly…
If I haven’t scared you so much you can’t bear to look, then you can find out more about these and lots of other aspects of managing distribution businesses (for both those in distributors and those in vendors) in my book: Distribution Channels – Managing and Understanding Channels to Market, published by Kogan Page, ISBN 978-0-7494-5256-8.
Go on check it out, you know it’s the “Right thing to do”.
Hardware distributor, Northamber reported its latest results to the Stock Exchange this week and has made redundancies as it deals with the fall in sales. It comments on two positive aspects, better margins and good cash reserves. It was, however, unwilling to express any view on the outlook and has posted a small loss in the first quarter of its financial year compared to a small profit for the same quarter last year.
With sales around the £180m mark for the year ended June 08, the profit of £627k is a classic example of net profit being a very small number between two very big ones. The problem for the management team is that profits have been close to break even for three years now – in other words the core problem is not the recession, but the strategic direction.
On the one hand it’s done a good job in controlling costs as sales decline, but on the other, how long can it continue to operate as a public company with such a low return on capital?
It is actually destroying value as the operating profit is less than the cost of capital, which is an unsustainable business model.
Vendors relying on Northamber as a route to market should be concerned as to the longer term outlook and should be asking tough questions about the strategy. With its cash pile, Northamber can afford to act decisively now to move to a new business model and direction. Leave it much longer and it could find itself with nowhere to go.
Why the urgency? Well £11m represents 22 days trading. So if vendors pull in their credit limits by 15 days and resellers take a week longer on average to pay their invoices, that cash pile will vanish. While Northamber can take action to control their Days Sales Outstanding, they may not be able to do much about the vendors view of credit risk.
The good news is that Northamber’s management team has been around, and stuck together, for a long time, but its shareholders may be wondering where the upside is.
For most companies, the Gross Margin is one of the most important measures of business performance. In this blog, we are going to show you why it could be the most dangerous measure during these recessionary times.
How can that be? Surely all profit is good, so more is better, right? Well, as they say, it DEPENDS…
Take a distributor, dealer or a retailer selling two products, that happen to have identical gross margins.
One (let’s call it a Widget) is a well known brand that practically sells itself, virtually never gets returned, works just the way the customer expected and comes in a square box that stacks neatly up to six feet high.
The other (let’s call it a Sprocket) is new in to the market, often gets returned because the instructions suffered in the translation and frankly it isn’t that reliable anyway, and it comes in some fancy packaging that involves several see through plastic bubbles and can’t be stacked.
You’re probably ahead of me here, but which one actually makes the most profit for the retailer? The Widget, – but hang on they make the same gross margin! How can that be?
The concept that applies here is call the Contribution Margin and it takes into account all the ways a product affects the dealer or retailer’s operating costs. So the Sprocket makes a lower contribution margin because it incurs:
a higher selling cost because it takes more time to sell as no-one’s heard of it before
a higher product support cost because customers keep asking how to make it work
a higher reverse logistics costs because it gets returned a lot
a higher warehousing, shipping and display cost because it’s awkward to handle, takes up more room and space in the supply chain and in the store
In retail, these costs are called Direct Product Costs and they are deducted from the Gross Margin. In other channels they are recognised as Variable Costs. Either way the Contribution Profit is calculated taking these costs into account and the Contribution Margin (Contribution Profit divided by Sales Revenues) reveals the true picture.
Why is this so important in recessionary times?
The contribution margin is so called because it is about measuring the contribution to fixed costs. And in recessionary times, it is the fixed costs that cause the problems because the lower level of sales can’t generate enough profit contribution to pay for them all. (And being fixed, means that it usually takes quite a time before you can take action that will reduce these costs, which include Payroll, rent, depreciation etc).
If you were to focus only on gross margins, you might think it didn’t matter whether you sold Widgets or Sprockets, but the contribution margin tells you that you will make a muich bigger contribution to fixed costs if you sold more Widgets.
Obviously as long as a Sprocket makes a positive contribution (ie it has a contribution margin > 0) then it’s better to sell a Sprocket than nothing. But if you can influence the customer, you’d want them to buy a Widget instead of a Sprocket.
So what can I do if I work for a widget or sprocket vendor?
The easiest thing you can do to improvee the contribution margin is to improve the gross margin. This might mean offering higher discounts, greater rebates (in return for increased sales volumes).
After that the best thing to do is to help with the marketing costs in the form of funding or special allowances. These could be tied to performance such as putting the product on display, into special locations or including it in special promotions.
Alternatively, the funding can be directed into special programs that focus customers on your product (but if the dealer or retailer incurs increased costs that you simply reimburse, then contribution is not improved).
Finally you can bear some of the costs, such as the reverse logistics, product support which work very directly on contribution; or increase brand advertising and promotion to increase consumer demand which works on lowering the cost of selling.
Does this mean Contribution Margin is the best measure to use in recessionary times?
It’s certainly the best Return on Sales measure, or margin measure. In the next blog, we shall show the best overall measure, which is a specific type of Return on Capital measure..and as we know capital is in rather short supply just now.
The Credit Crunch and Recession seem to be inextricably linked, but the impact of these two economic events is quite different. And this difference applies especially to Retailers, where the Recession will have far greater and more damaging consequences than the Credit Crunch.
If your business depends upon the Retail channel, then you should be taking action now to help your channel whilst, at the same time, protecting your own interests.
Recession versus Credit Crunch A Recession is something we see on a cyclical basis to a greater or lesser degree and anyone over 30 will have lived through at least one major recession. It is in essence a period when demand weakens as confidence evaoprates. The Credit Crunch by comparison is a much rarer event that last ocurs when the bad lending judgement of the world’s banks come home to roost in such a way as to destroy capital and remove liquidity from the economic system. In this current situation, a combination of dodgy loans based on property and increasingly exotic instruments that leverage the risk have been exposed by a sharp fall in the underlying property values. The effect is to suck credit out of the economy as banks become unwilling to lend to each other and thus to businesses. The two events are linked and feed on each other, but their impacts are very different.
The impact on the Retail channel
Retail is all about making high volumes of sales at good enough margins to cover the overheads of the business. Almost all sales are for cash or cash equivalents (credit card slips turn into cash overnight) whilst suppliers are paid on credit and inventory is kept to a minimum. Many retailers use their huge buying power to extract extended credit so can sit on a cash float for a month or so before paying their suppliers. Tesco for example is sitting on a cash pile of £2bn, Best Buy used to hold around $1.5bn (more on why this has come down to 0.5bn later) and Walmart has $7bn. The fundamental business model is to sell for cash and pay on credit, so the the credit crunch does not put their business at risk in the way that businesses that sell on credit are becoming exposed.
What does affect the Retail business model is the Recession because this damages sales volumes over a longer period. It’s akin to a coastal farmer survivng a Tsunami, but then suffering the effects of losing his home, crops and equipment. The lack of credit in the economy compounds the damage caused to confidence….and an uncertain consumer stops buying. Hence we have seen the shift to thrift as value brands benefit (Aldi, Lidl, Primark) in grocery and apparel, but other sectors such as household, electricals, fast moving consumer goods, consumer electronics, fashion, Do-It-yourself, have seen sales fall off a cliff. Retailers have fixed overhead costs (staff salaries, rents and utilities, distribution and IT systems) that are hard to cut quickly, so falling sales leaves their overhead base exposed like rocks as the tide goes out. This means net profits can quickly turn to net losses, eating into those famous cash piles.
Some costs related to marketing and promotions can be cut quickly but these are the key to another factor – getting customers to the store. In hard times, most businesses look at their order book as a leading indicator of how things are going to go. In other words they can see what is going to happen to sales beforehand. Retailers don’t have order books – they open the doors each day and wait to see who they have enticed into the store. That’s why everyone anxiously watches the daily sales numbers like a hawk – the trouble is this is a lagging indicator. By the time you know what’s happening, it’s happened.
What can Retailers do in a Recession? There is a fairly familiar pattern to what vulnerable retailers do (none of which they really want to do):
Cut back on planned store openings (new stores take time to reach profitable sales levels and even longer in a recession). The trouble with this is that it leaves the retailer increasingly in the wrong part of town
Put pressure on suppliers to help finance more aggressive marketing and promotional activity. Tesco recently announced it was asking its non-food suppliers to make a contribution of up to 5%.
Trim overheads by making a thousand small cuts while staff hiring is frozen. This means the best staff leave for places that treat them better and tends to harm staff morale, damaging customer service. Both Circuit City and CompUSA were slated for customer service in the period before their demise
Discount deeply to keep the inventory moving. Lower sales means slower turning inventory, which means holding old or out of season inventory.
Delay or minimise store refurbishments and resets. This leads to tired looking stores.
Close Stores (Circuit City closed announced it was closing 20% of its stores a week before it filed for bankruptcy
Shift promotions to “item and price”, in other words, any emphasis on positioning, value proposition or retail brand values is replaced with simple price-led programs.
On the other hand, strong retailers do the opposite of these things. Look at Walmart: Chief executive Lee Scott said Wal-Mart would be taking a “thoughtfully aggressive” approach to any opportunities, which might include acquiring sites from retailers that have gone out of business. He said under these circumstances there were chances to negotiate “very good rents”. The retailer said it was looking at smaller store formats while focusing more of its efforts on online sales to drive growth, according to The Financial Times.
So it shouldn’t be too hard to work out how well your retail partners are coping with the recession using the seven key points above.
Last week Tesco announced that it was extending its payment terms to non-food suppliers by one month. This week Computacenter and DSGi did the same (channel web news). In doing so they joined the Forum of Private Business’s “Hall of Shame”. Click here to see if any of your partners are already listed there for late payment practices.
Many of the vendors who rely on these go-to-market partners have no choice but to accept the new terms or risk losing a vital chunk of their market access. But what is the cost to them of this move? How much extra cash is required to fund the new terms at current volumes?
The cost of extended credit
Here’s an illustration assuming $10m of sales is made to the partner:
Sales to partner $10m
Increased credit taken by partner 30 days
Cost of capital (typical) 12%
Cost of extended credit is $10m x 30/365 x 12% = $82,192
This is 0.82% of sales, which could be almost a fifth of the net profit from sales to this partner if the vendor is making say a 5% net profit.
Extra cash required to continue trading at current volumes
Assuming our vendor can take that kind of hit to its net profitability, does it have the cash reserves to be able to do so?
Extra cash required = $10m x 30/365 = $821,918
So the vendor needs to pump almost an extra $1m permamnently into its working capital investment in this partner…
Is it worth it?
The key measure to apply here is the return on working capital that the go-to-market partner delivers and to balance that against the strategic need to be present in that partner for credibility and market access. In some situations, there is no alternative, so the vendor has to accept its cost of going to market just increased (and Computacenter and DSGi are clearly leveraging their power in the value chain in making their move). For those vendors that do have options, then here is the relevant calculation:
Net profit on sales = 5% on sale of $10m = $500k
Working capital invested in partner = 60 days sales = $10m x 60/365 = $1,644k
Return on working capital = $500k/$1,644k = 30.4%
(Note that before these partners took extended credit, the return was double this at 60.8%)
If the vendor believes that the extended credit is going to be a permanent move (which is likely as most large retailers have established 90 days terms), then it has to ask itself if this is a sustainable business model. If not, then the vendor must start growing its partnerships with other go-to-market partners to shift business through them and away from the Computacenters and DSGis – even if at this stage, the changes are small steps.
For many vendors, partners such as Computacenter and DSGi are critical routes to market and this move will be a major shock to their profitability and return on capital. These vendors will need to find ways to leverage their increased investment in these partners – ensuring they are reaching and penetrating their target customer segments, growing their brand visibility and increasing their share of their partners’ resources and sales capabilities.
Questions? Other challenges? Other topics you would like to see covered? Respond to the blog or email Julian Dent at jdent@viaint.com
Right now most businesses in the world of IT sales and distribution are doing two things – trying to finish 2008 without going bust and planning to survive in 2009, if not actually thrive. Be they manufacturers, distributors, resellers, retailers or etailers, the realities of running the business under these dramatically changed conditions are the same. Cash is key to survival, but simply monitoring the bank account will not be sufficient. And if you are relying on one or more channel partners to be around for a while yet to achieve your sales objectives, you need to know how likely they are to succeed under the credit crunch. In this blog, I am going to set out a few indicators that will help you tell if your partners are likely to make it through 2009, and some things you can do to improve their chances.
Liquidity – what is it and why does it matter?
First things first, is the partner going to make it through 2008? That all depends on its liquidity and its vulnerability to the changes in its customers’ behaviour and that of the banks. Liquidity means simply that the business has enough cash flowing through the business that it can pay its bills as they fall due. Often the first bill that causes a crisis is the payroll, as there is no scope for negotiating extended terms with employees. This is especially true of people-based businesses such as VARs and higher value dealers. After that it’s the statutory payables such as payroll taxes, VAT and other taxes, because the authorities don’t usually negotiate.
How can you tell if a business has enough liquidity? It should have been running a normal balance sheet before the credit crunch took hold where its current assets (inventory, receivables and cash) were greater than its current liabilities (payables, current portion of loans and overdrafts). Now it is especially critical that this is true. In fact it’s better to use what is known as the acid test: receivables and cash must be greater than current liabilities. This is because the bills may need to be paid before the inventory can be cycled back into cash.
When the credit situation gets tough, the tough … ask for more credit
Next look at what happens if the game changes. Tesco, a leading retailer has just unilaterally changed its payment terms from 30 days to 60 days for its non-food suppliers. Any distributor or manufacturer doing business with Tesco now needs to finance that extra 30 days credit, which is costly (it will take another 11.7% of sales to recover the extra cost), but more importantly sucks cash out of the trading cycle. If you were doing $1m of business with Tesco, you would now need another $82,000 cash just to keep trading at the current volumes. For most distributors, only a few of its customers (usually retailers) have the power in its trading relationship to do that to them, but for many resellers, most of its customers may have the power to extend their credit taken, extending the cash-to cash cycle. How much strain can a business take? As a rough guide, most banks would have financed up to around 50% of the equity (share capital plus retained earnings) in the business. Today these limits are nearer 30% and often lower. You need to know how your partners stand in the power play with their customers in terms of being able to resist moves such as that made by Tesco. Instead of special pricing for deals, you may find the conversation will move to special credit for deals, enabling the dealer to pass the working capital burden to the vendor with the strongest balance sheet.
Beyond survival
Having enough cash and working capital to cope with tightened credit and demanding customers is one thing, but what do the plans for 2009 look like? One of the key tests we apply to any business is to look at whether that partner is creating value or destroying it. This means comparing the operating profit of the business to the cost of the capital employed in the business. If operating profit is greater, management has created value and if operating profit is smaller, then management has destroyed value. This may have seemed to be a bit of accounting jargon before, but in these times of very scarce capital, it is the ultimate measure. For example, if a business has $100m capital employed, then at today’s real rates, it will be costing it at least 10% to have secured that capital from its sources (shareholders, banks etc). So the business must make $10m operating profit before it has created any value at all. Note how this is lot more challenging than simply establishing a net profit versus a loss. It relates the profit to the resources used in making that profit. The plans for any partner for 2009 need to show how it will create value if it is to have any real chance of doing more than just surviving.
What can you do to improve your partners’ chances?
You need to do a rough calculation – is your “business model inside” a net enabler or a net drag on your partner? By business model inside, we mean the business model of your products in terms of the profitability and working capital requirements as they pass through the partner. To do this, first compare the operating profit your partner makes on your products to its average: Are your gross margins higher or lower? Will your contribution to overheads be higher or lower? Would the partner net out with better operating margins (ie the net margin before interest costs) if it just sold your products? Let say its operating margin is normally 2% of sales but for your products it is only 1.5%.
Do the same for the working capital required. Let’s say that its normal working capital requirement is 75 days as it has to pay most suppliers on 10 or 15 days to secure competitive margins, but for your products its requirement is 50 days as it can take 30 days to pay you without penalty. And let’s assume your business is worth $1m of sales a year out of the partner’s total sales of $5m. Calculating Value created on your business:
Working capital required: $1m x 50 days/365 days = 137k
Apply 10% interest costs to the working capital of $137k = $13.7k
Operating profit: $1m x 1.5% = £15k
So the value created is $15k operating profit less the $13.7k cost of capital = $1.3k
Comparing this to the partner’s overall business model:
Working capital required: $5m x 75 days/365 days = 1,027k
Apply 10% interest costs to the working capital of $1,027k = $103k
Operating profit: $5m x 2% = £100k
So the value destroyed is $100k operating profit less the $103k cost of capital = $3k
In this example, you should be leveraging your better working capital profile to both grow your share of the partner’s business and to turn its value destroying model into a value creating one. If the partner does not do this, then it will probably begin to fail in 2009, as it will not be generating an acceptable return on its capital, putting its sources of capital at risk…and therefore its liquidity – something you know it cannot afford to do.
What should you be doing now?
Here’s a checklist of the topics should be covering in your next conversation with your partners:
How are customers reacting to the credit crunch and general market conditions?
Have credit limits from suppliers/distributors changed recently?
How is the effect of these changes affecting the cash to cash cycle and liquidity within the business?
What actions is the partner planning to take to respond in the short term?
What role can you (as a strategic partner) play in these actions?
How secure are its sources of funding for 2009 and what is likely to happen to its cost of capital?
How does the net profitability on your lines compare with that of the partner’s overall business?
How does the working capital cycle compare?
What actions is the partner planning to take to improve these two elements of its business model in 2009?
What role can you (as a strategic partner) play in these actions?
Need more help? Found a situation not covered by the above?What issues should the next blog address?
