Its easy to lose your business through operational failures

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: –

  1. Sales – the top line
  2. Direct costs – the two mains one often being “raw materials” and “direct labour”
  3. Gross profit (GP) – sales less direct costs
  4. Overheads – including interest, depreciation etc. because these are all costs affecting the profitability and sustainability
    of the business
  5. 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.

How the wrong strategy can destroy a business

If your business is running into difficulties bring in help
as soon as possible. That was the message in my last blog. In this article I
look at some of the strategic failures that drive businesses under. Whilst I’m
not using names or other details from which individual businesses can be
identified, everything I describe here has actually happened; so it’s real.

Consider a manufacturing business selling B2B. Built up over
20 years to reach a substantial turnover, good profits, low gearing and a great
market position, its founders sold the business to the management, with venture
capital support. At this stage, only two things really changed, the “presence”
of the founders was absent and the gearing increased. Initially everything went
well; but the new owners then decided to go for an acquisition. So they bolted
on another very similar business doing much the same, except it was smaller,
not as well run and in a different part of the UK. Funding the acquisition
required further borrowing, interest payments soared, management was stretched
geographically, overheads of the combined business weren’t stripped out quickly
enough and the market took a downturn. BANG.

In my view, The MBO was OK. The problem was the acquisition,
particularly for a new untested management team. The VCs pushed the acquisition
and the management was flattered; but the strategic justification for the
acquisition was never really clear. Were they buying market share? If they
were, they should have stripped out all duplicated costs and as much overhead
as possible to make the combined business as lean as the original business; but
they didn’t. Or were they buying into a new market segment? In this case they
would have managed the new business at arm’s length to allow it to flourish in
a segment they knew less well. However, the new business was in the same
segment as the original business. The problem was that, with no clear
acquisition strategy, they actually bought market share but behaved as if they
were buying into a new market segment. So what we learn from this is that you
don’t acquire a business because you can or because it’s available; it must be
part of a very clear and properly developed acquisition strategy.

Now consider another manufacturing and service business
selling B2C. It was another VC backed MBO. It was a significant player in its
market, operationally efficient, very profitable and growing substantially year
on year. So its business model was robust and working well. Or was it? A market
analysis showed that, although it was growing, its growth was underperforming
that of the market. So, despite its growth, it was losing market share. This
should have been a warning sign that all was not well; and that perhaps the
business model wasn’t as good as the management perceived it to be. But the
warnings were not heeded and then the market turned down. The business
continued to lose market share; but now it was losing share of a falling market;
and its sales went into a steep decline until it had insufficient critical mass
to survive. BANG. The message is clear. Ensure you continually review your
performance in the market, listen to what the market is telling you and act on the
warning signs when they appear.

How about an old established family business founded in the
early years of the 20th Century. It had three relatively diverse
operating divisions with both B2B and B2C activities. Ownership was in the
hands of 13 shareholders spread over two main families. No individual shareholder
had control and each of the two main family groupings had 50% each. Of the 13
shareholders, only 4 had worked in the business, within the ten years before
its demise and the role of CEO had passed from one elderly shareholder, from
one of the families, to another elderly shareholder, from the other family. The
remaining 9 shareholders had no managerial or operational involvement at all
but wanted to be consulted about even low level decisions. Add to all this, the
fact that there had been a long established rift between the two families and
it’s not hard to imagine that the business was suffering from complete inertia.
This may all sound farfetched; but it’s true. The business had become paralysed
and, although a rescue attempt was made, it was too little too late. BANG. This
shows the importance of getting the ownership and management of family
businesses properly structured, with professional management drafted in where
appropriate and with individual shareholders clear about their responsibilities
and the consequences of their actions.

My final example is a manufacturing business selling B2B
that was family owned and which had been reasonably successful over many years. It was concerned that its market was changing and that its products, which were components for the assembly of the finished products, undertaken by its customers, was in decline.

This assessment was probably correct and its long term sustainability
would require some form of diversification. The least risky direction of travel
would probably have been to move progressively towards the final assembly of
the product. The demarcation between its market position, as a components
supplier, and that of its customers as assemblers was already disappearing –
hence its initial problem – so formalising that position and marketing the
finished product under its own brand was a fairly logical step.

However, it withdrew from the supply of components before it
had fully established its new customer network and thereby scored a serious own
goal as its sales fell significantly. But it compounded the problem by
developing several ranges of complimentary products, of which it had limited
experience, and opening new sales channels into new market sectors, of which it
also had very little experience and for which it was not appropriately
resourced. Focus was taken away from the core business; and the new products
and market segments made heavy losses.

The result was that sales continued to decline, even with
the new products and market segments, and the business, as a whole, started to
accumulate losses. Perhaps the saddest thing of all was that, despite the
deteriorating financial performance, the balance sheet was originally strong
enough to withstand some of the early losses and, if the business had come to
terms with the failure of its strategy and changed course, it could probably
have been saved. But it was in denial; and wouldn’t budge. BANG.

The first message here is that any change of strategy needs
to be properly researched, properly planned, properly resourced and properly implemented. In addition, the level of risk needs to be assessed and understood, before embarking on any major strategic change. This business had a hugely ambitious change programme, for which it had neither the skills nor resources and it had little or no understanding of the risks it was running. The second message is, if a new strategy is clearly not working, come to terms with it, remember that the first loss is always the best loss, swallow your pride and change course.

All business failures are different and all I’ve done here
is to give a few examples of businesses that have failed for strategic factors;
but they actually represent some very common themes and highlight some
important principles. Acquisition and diversification strategies involve huge
risks, albeit they can also provide some major benefits; but they need to be
very robust and cannot be handled in a cavalier manner. The market is full of
messages for each and every player; listen to it. Family businesses can fail as
a result of family factors rather than commercial ones.

Next week I’ll be looking at how operational factors can undermine
businesses. But my final message here is to repeat that, “If things are starting
to go wrong bring in help urgently; and even if things are going well, an
external strategic review may well identify potential problems at an early
stage, enabling you to take action before the position becomes serious. Yes
it’s a plug for work for people like me; but people like me can bring an
external perspective, broader based experience and objectivity to managements
that, by definition, tend to be focused on the day to day.

If you want to contact me direct, call me on 07770 816468
(+44 7770 816468 from outside the UK) or email anthony.pratt@imc-consultancy.com

 

Most business failures are own goals

I’ve spent most of the last 30 years working in and around businesses that are in some form of flux or transition. For 10 of those years I was an employed CEO working within a corporate environment, where I gained a reputation for turnarounds of problem business units. For 5 years I managed troubled SMEs, which took me through a whole new learning curve. And for the last 15 years I’ve been a management consultant or troubleshooter helping under performing businesses get back on top.

I can’t claim to have seen it all; but, I’ve seen many different businesses making many different mistakes; sometimes they’ve recovered from those mistakes and sometimes they haven’t. But there is one thing, of which I’m certain; most business failures are own goals and most could have been avoided if appropriate action had been taken, when the first signs of trouble appeared.

In the coming weeks, I’m going to publish a series of blogs that deal with the types of mistakes that can and do lead to failure. Broadly speaking, they can be put into four categories, namely “Strategic”, “Operational”, “Organisational” and “Leadership”; although, in practice, a business’s demise may well involve more than one of these categories. But before I do that, I want to emphasise, in this blog, the one over-riding factor that contributes to most business failures, and that is the failure to act soon enough.

When a business first starts running into difficulties, there will normally be a range of options available to it. This could include some form of refinancing or external investors; it could include some form of strategic change or capital investment; it could include some form of downsizing or restructuring; it could include changes at board or senior management level; and it could include many other factors besides.

However, as the failure to recognise the problem continues or as the failure to take action is delayed, the number of options open to the business start to reduce. And as the options reduce, so do the chances of recovery or turnaround. Too many businesses fail simply because they leave it too late before they take action.

So why do businesses leave it too late?

I’m sure everyone reading this will have their own views; but in my experience, there are probably three main reasons.

The first is that the business doesn’t realise that it has a problem. This could be the result of management losing focus; it could be due to poor management information within the business; it could be due to a lack of market intelligence; or it could be due to a lack of knowledge of changes within key areas of the external environment.

The second is that there is disagreement amongst directors/shareholders/senior management about the seriousness of the problem or what action to take. This can and does lead to paralysis.

The third is that directors/shareholders/senior management have put a great deal of personal kudos into a particular project or strategy and are simply unwilling to accept that it isn’t working; so they don’t take remedial action until they are forced to, by which time the options available to them have started to disappear.

The frustration for consultants like me is that we are often called in when it’s too late. We’re seen as a last resort rather than part of the ongoing health programme of the business. This probably sounds like a plug for work; and yes it is – unashamedly so. But actually, the best time to call us in is when everything appears to be going well. It’s exactly the same principle as having a personal medical health screen every couple of years or so. Early detection is infinitely better than discovering a condition when it has become acute; and its no different for a business.

Next week I’ll be writing about some of the strategic reasons for business failure; but, if your business ‘s performance has started to dip, particularly in the light of today’s challenging market conditions, bring in help now; don’t leave it too late. And if you’d like to talk to me, call me on 07770 816468 (+44 7770 816468 from outside the UK) or email me at ap.apconsultants@btinternet.com