In my last blog I looked at some of the more common strategic errors that can result in businesses going bust. I’m now moving on to consider some of the more common operational mistakes that can produce the same outcome.
Consider a manufacturing/service business selling B2C. It’s stable, neither growing nor shrinking and it’s breaking even. Its cash is collected from its customers, partly as “deposit with order”, and partly on “delivery/completion”. Its creditors are paid on deferred terms. So it collects its cash before it pays its suppliers, employees, and most other creditors. As a result, it’s “cash positive” with a cash surplus, which fluctuates with day to day trading but, overall, remains relatively static.
Now consider what happens as the conditions change. If everything else stays the same, except that the business starts to make a profit, then the cash surplus will grow, as a result of those profits. If sales then start to grow, the cash surplus will grow even more, opening up all sorts of new opportunities and horizons.
But what if, the business starts to lose money? The answer is, of course, self-evident; the cash surplus will shrink and eventually disappear. The business will then need to start borrowing and, ultimately, if the losses continue, it will go bust.
So far, this is all fairly straight forward. But now let’s consider a slightly more complex scenario. Let’s say the business starts losing money but, at the same time, sales start to grow. The effect of the losses will be to reduce the original cash surplus; however, the effect of the additional sales will be to increase the cash surplus. So, if the additional cash, generated from the incremental sales, exceeds the cash outflow, resulting from the losses, the business can continue to trade quite happily, with a growing pile of cash. And this happens all too frequently with B2C businesses.
The crisis comes when sales stop growing, as they inevitably will at some point. When this happens, there is nothing to offset the cash outflow, from the losses, and so the cash surplus starts to shrink. In many real life situations, the problem is often made even more acute, because much of the surplus cash will already have been spent on other things, leaving only a small buffer, which doesn’t last very long and soon leaves the business insolvent.
Many B2C businesses fail for this reason. The size of the cash surplus is too often seen as the sign of a successful business. But if the “profit and loss account” (P&L) is not properly monitored and losses are allowed to accumulate, the cash surplus is of no lasting use whatsoever. Businesses must make profits to be sustainable and that is not necessarily the same thing as generating cash.
Now let’s consider the opposite scenario. Take a manufacturing/service business selling B2B. It extends 60 day terms to its customers but pays its suppliers in 30 days. This is a relatively common scenario; and it means that, unlike the B2C examples, we’ve just been considering, sales growth consumes cash rather than generates it. So funding growth, in this situation, requires cash generation from a healthy bottom line; and the life expectancy of a loss making business is likely to be very short.
The problem for many businesses, in this scenario, is that they get caught up in a viscous cycle. They are profitable; but only just. The profits, they make, don’t provide enough cash to fund even a modest growth plan. The banks won’t give them sufficient overdraft facilities. So they opt for invoice discounting or full factoring, which adds significantly to their costs and depresses their profits still further. Once in this cycle, it’s very difficult to break out; and there are many SMEs running very hard just to stand still. Unfortunately, businesses like this are very vulnerable; and it only requires a bit of bad luck – a sales downturn, a bad debt, an increase in key raw material costs etc. and it’s game over.
Whilst the different cash flow characteristics between B2B and B2C businesses, create different challenges, the underlying strength of both types of business must be based on having a very healthy bottom line. Sadly, many business failures, whether B2B or B2C result from trying to grow from a platform that is either unprofitable or only just profitable, rather than focusing on creating a strong and profitable foundation that is capable of supporting growth.
So now we’ve established the importance of a healthy P&L, let’s look at why some businesses fail to achieve it and leave themselves vulnerable.
Banks, VCs and other potential stakeholders often look at EBITDA – “Earnings Before Interest, Tax, Depreciation & Amortisation”; and businesses within a corporate or group structure often report at operating profit level i.e. profit before tax, management charges and, in some cases, depreciation. This is because investors and banks tend to look at underlying performance that could be continued under different ownership and different capital structures. Large groups also like to measure the underlying performance of their businesses, which can sometimes be obscured by group allocations of depreciation, interest and management charges. But for most independent SMEs there are five key lines on a P&L. These are: –
- Sales – the top line
- Direct costs – the two mains one often being “raw materials” and “direct labour”
- Gross profit (GP) – sales less direct costs
- Overheads – including interest, depreciation etc. because these are all costs affecting the profitability and sustainability
of the business
- Profit before tax (PBT)
From here on, let’s think in percentages with sales as 100% and everything else expressed as a percentage of sales.
If a business wants a PBT of 10% of sales, there has to be a balance between gross profit and overheads to deliver it. A high overhead business – perhaps it has a high R&D facility or is highly capital intensive, involving substantial depreciation – needs a high GP. For example, if overheads are running at 50% of sales, a 60% GP is required to deliver a 10% PBT.
By contrast, if the overheads are only 10% of sales, the GP required to deliver a 10% PBT is only 20%.
The potential PBT, GP and overheads will vary considerable from sector to sector and, to a lesser degree, from business to business, within each sector; so there is no “one size fits all” solution. The skill is to get the balance right for the individual business and set of circumstances. However, we’ve already seen the importance of making a healthy PBT and so the overall balance between sales, GP and overheads must be driven from the bottom line. Everything needs to be structured to provide that healthy return on sales, which, in the majority of SMEs, is likely to be upwards of 10%.
This would be relatively easy if prices could be increased to suit any given level of direct costs and overheads without affecting sales volume; but that is rarely the case. Selling price is normally governed by the market; although there is usually a price range that is dependent on the business’s competitive position in its sector – I’ll be looking at this in more detail in future blogs. In addition, the rules of supply and demand apply i.e. relative to the business’s market position, the lower the price, the higher the sales volume; and the higher the price, the lower the sales volume.
So, in practice, many businesses find their direct costs and overheads are squeezed between the demand for higher PBT, on the one hand, and market pressure on the price/volume equation, on the other.
Do we reduce prices to increase sales? If we do, the %GP will fall. But will the additional volume created be enough to produce more GP in total? If it does, overheads will be diluted and PBT will increase. So we have a win.
But what if %GP falls and the additional volume isn’t enough to generate more GP in total? Worse still what if %GP falls and there is so little additional volume that the total amount of GP generated also falls?
Now consider overheads in all of this. If more volume is generated, can the infrastructure support it? If higher volume entails more staff or additional investment in systems & IT etc., how does this impact?
These are complex relationships, even in relatively small businesses; and a common error is the “busy fool syndrome”. The business chases volume; unit prices fall; margins fall; costs go up; and instead of PBT improving, it deteriorates.
This tends to happen in weaker and more vulnerable businesses. They’re probably making losses or minimal profits; their cash flow may well be stretched; and they see incremental volume as their salvation. However, for the reasons I’ve described, it rarely is and sadly, it often leads to insolvency.
Let’s now change the focus away from sales and look at the relationship between direct costs and overheads. If we want PBT to run at 10% of sales, the total of all costs must not exceed 90% of sales. Most businesses, making a 10% return on sales would deem themselves to be reasonably successful. But bearing in mind that 90% of sales is then accounted for by costs, the margin for over run on those costs isn’t great. So their management and control is critical.
How often do you hear people talking about the need to control overheads? If you’re anything like me, it’s something I hear constantly. But how often do you hear people talking about the need to control direct costs? In my case this isn’t so often. And yet, in many SMEs, direct costs are substantially greater than fixed costs.
I would submit, that a key contributor to a profitable business is to have the processes within that business working very efficiently and very cost effectively. And that means focussing very hard on direct costs; productivity and procurement often being the two main focal points. Drive the direct costs down; generate a healthy GP; and there’s a really good chance of having a successful business.
Of course it’s also important to control overheads robustly. And they must be proportionate to the size of the business. But in general, overzealous control of overheads that results in under resourcing the processes and systems can be very damaging to the sustainability of the business.
Businesses are much more likely to fail because they generate inadequate GP than because their overheads are too high. Some people may question this statement because, at the time they fail, many insolvent businesses do have overheads that are too high. However, in most of these cases, their overheads weren’t too high originally, but became proportionately higher as the business declined. High overheads weren’t the key driver behind the decline but became a problem because they weren’t reduced sufficiently during the business’s demise.
This article deals with a number of operational factors that can contribute to the failure of a business. But what I hope comes through is that the single most important factor is that the operational activities of the business, whatever those are, are lean, very efficient, very cost effective and able to deliver high margins, relative to the market sector concerned. But in addition to the effects on the P&L, operational efficiency also provides a significant competitive advantage in the market place that helps offset the need for price cutting and the temptation towards the busy fool syndrome. Businesses that fail for operational reasons tend to place too little emphasis on operational efficiency, fail to understand the consequences of doing so and assume that poor operational performance can be offset through strengths in other areas, which is seldom the case.
In my next blog, I’ll be examining the way that structural and leadership issues can push businesses into insolvency.