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This first article in a three-part series will highlight how to methodically create a financial appraisal of your firm’s current financial position and determine the amount of financial slowdown the business can tolerate before starting to lose money.
As distribution companies tear up their financial projections originally forecasted for 2020, many are looking for a sound path forward. In an exclusive on-demand webcast for MDM, Al Bates, principal with distribution research group Distribution Performance Project, describes how to start the process. Based on decades of market experience and observations from previous downturns such as post-September 11 and the Great Recession, he recommends a three-step approach to finding your financial footing.
1) Outline a financial appraisal of where the firm stands. Position yourself on the spectrum from panicked to relaxed by focusing on two critical rations: profit and cash position.
2) Identify key mistakes from the past to be avoided. In economic downturns, distributors tend to repeat the same mistakes or bad decisions, Bates notes. Recognize they happened and develop a plan to avoid repeating them.
3) Create an action plan to improve long-term financial performance. Ask yourself, what do we have to do so that we’re in a much better position coming out of this than we were going into it? How can we position our company for long-term success, Bates says, knowing that maybe 10 years from now there’ll be another challenge that we face?
To begin outlining a financial appraisal of where the company stands, Bates uses a fictional distribution company, Mountain View, Inc., with a financial statement he estimates would cover up to 75% of U.S. distributors today. [See Exhibit 6 below.] The distributor has $20 million in net annual sales with a 25% gross margin. The crucial point to note and keep in mind, Bates says, is that for virtually every distributor across sectors, about two-thirds of expenses come from payroll. “As we start talking about trying to improve performance in today’s environment, we’re going to have to have payroll rear its ugly head,” Bates says.
As seen in Exhibit 2, the company’s expenses subtracted from gross margin result in a profit of $500,000 or a bottom line of 2.5%.
Fixed and Variable Expenses
To move forward and respond to today’s market environment, Bates suggests breaking out the expense category — in this example $4.5 million — into two components: Fixed and variable. “Most small companies have never done this, and a lot of large companies have done it but done it incorrectly,” he says. “It’s absolutely essential to understand what’s going to go on as the world changes.”
Fixed expenses only change when an action is taken. For example, responding to the current economic situation by actively reducing expenses such as travel and education. This type of reduction would not happen automatically. It needs to be initiated.
In contrast, variable expenses change automatically. When sales go down, variable expenses go down proportionately. Important to note, Bates says, most companies overestimate their variable expenses, assuming that more expenses will go down when sales drop than actually do decline.
Looking at the fictional Mountain View, Inc., balance sheet. The company has:
• $200,000 cash
• $2 million accounts receivable
• $4 million inventory
• $800,000 accounts payable
“Most distributors do not have a lot of cash. Banks have cash. Distributors have something else, namely accounts receivable and inventory,” Bates says, noting this company has $6 million tied up in this fashion. “We might want to think about how do we drain those effectively, or even should we drain them at all?”
Under AP, the company owes suppliers $800,000. While many distributors may panic a bit about the $400,000 gap between amount owed and money in the bank, this area is not typically a problem, Bates notes, as payments often flow out throughout the month. “As long as the railroad keeps running, it is not a problem,” he says. “It only becomes a problem when the railroad slows down or comes to a halt. Prior to the present situation, I was relaxed about these numbers.”
Two Key Survival Ratios
When determining how to deal with a market slowdown, there are many ratios that a distributor can look at, but two of the most important are breakeven point and collection sensitivity ratio, Bates says.
1) Breakeven point. How much of a sales decline can the firm manage without resorting to desperation measures? Desperation measures go beyond cutting typical ‘extras’ and get into critical infrastructure cuts, Bates says. “My concern is in a down market we cut infrastructure. When the market comes back, we add it. We cut it, we add it, we cut it, we add it. It’s dysfunctional,” he adds.
2) Collection sensitivity ratio. How much can collections lag before the firm faces a severe cash crisis? The real challenge in the down market, Bates says, is customers begin to pay slower. How much can a distributor afford to have a lag before serious issues arise?
To figure out what happens when sales stop or slow severely, distributors need three numbers, according to Bates:
1) Gross margin percentage
2) Fixed expenses in dollars for the year
3) Variable expenses as a percent of sales
Those numbers create a formula: fixed expenses divided by gross margin percentage minus variable expense percentage. This lays out the fact that every dollar of revenue coming in isn’t actually a dollar. With a 25% gross margin, 75 cents of every sales dollar go to suppliers, plus the 5% variable expenses.
The formula to find the break-even point is as follows:
Using the formula with fictional Mountain View, Inc., the number needed to break even is $17.5 million. Anything below this will wipe out profit.
Implication of the Breakeven Ratio
The majority of distributors can take about a -12.5% sales hit before they begin to go to a negative profit, Bates says. He suggests a 20% safety factor as a goal to strive toward. The percentage comes from observing sales decline during both the September 11 and Great Recession downturns.
“We don’t have a 20% safety factor now for most of us, but the next time we have a problem, I want you to take an oath that you’re going to reengineer your business so you can take a 20% sales hit and still be marginally profitable,” he says.
In this example of finding the breakeven point, Bates notes that fixed expenses do not drop for Mountain View, Inc., while variable expenses decline with sales, lowering total expenses slightly.
However, he recommends individual distributors look at their fix expenses and make a decision, for the year in its entirety, if it might be smart to also reduce fixed expenses. “You’ve got to decide, in this entire year, what’s going to happen to my sales,” he says. “You have to decide, what sort of situation do I have with my breakeven point?”
January and February were relatively nice months for many distributors. March was marginal, and April saw some significant declines.
“I want you to decide going forward, are we going to have a bunch of Marches? Are we going to have a bunch of Aprils? Are we going to have a bunch of Januarys or Februarys?,” Bates says. Ask yourself, “What am I going to look like? Decide to what extent do I need to begin to hack those fixed expenses — or not hack them? I can only provide the structure. You’ve got to decide.”
In part two, Bates outlines how to take this data to create an action plan to improve long-term performance. Meanwhile, view the on-demand webcast here.