MDM is providing this Premium content for free so that everyone can access important information about the ongoing impact of the coronavirus on distribution. For more, sign up for our MDM Update newsletter.
This is the second article in a three-part series for distributors to improve long-term financial performance. Part one addressed first steps to create a financial appraisal of your firm’s current financial position. Part two tackles profit improvement variables and key mistakes distributors make.
As noted in part one of this series, Al Bates, principal with distribution research group Distribution Performance Project, in an exclusive MDM webcast described how to begin outlining a financial appraisal of your distribution company from a position of profit. Here, Bates continues the discussion with how to examine the company’s cash position, followed by how to recognize repeated mistakes in order to avoid making them again.
Bates illustrates the example through fictional distribution company Mountain View, Inc., with a financial statement he estimates would cover up to 75% of U.S. distributors today. The distributor has $20 million in net annual sales with a 25% gross margin. (See chart below.)
To establish the company’s cash position requires two ratios. First, the collection period (DSO). How many days does a typical customer take to pay? Most distributors do not look at their collections per day, but Bates says you will need this information to calculate the DSO. How much money comes in each day from past credit sales? For Mountain View, Inc., the collections per day equal $54,795 ($20 million net sales divided by 365 days in a year).
To calculate the DSO, take accounts receivable (discussed in part 1 to be $2 million for Mountain View), and divide it by $54,795 collections per day. This equals about 37 days collecting $54,795 every day until AR reaches zero. Having this number allows a distributor to calculate its collection sensitivity ratio, which is cash on hand divided by collections per day. “What I’m really asking myself is, how much slower could people pay us before we eat up the cash?,” Bates explains.
With $200,000 cash on hand, divided by the collections per day total of $54,795, Mountain View will run out of cash in about 3.7 days. This represents a 10% gap (3.7 days divided by the 37-day collection period). Although 20% would be “the magic number,” Bates says not to panic if your company, like the fictional Mountain View, comes in below that threshold. Other factors like line of credit and slower supplier payments can potentially help make up the gap.
Profit Improvement Variables
In most industries, Bates says, companies fall into three profit categories:
1) Typical: 2.5 % profit margin, with sales decline leading to break even at 12.5%
2) High profit: 5% profit margin, with sales decline leading to break even at 25%
3) Low profit: 1% profit margin, with sales decline leading to break even at 5%
Roughly the top 20% of companies fall into the high-profit category that would allow them to take a 25% hit. The goal is to reach that 20%. To start making your way (or stay) there, Bates recommends monitoring the relative impact of improvements in critical profit variables (CPVs) on profit before taxes (PBT).
Five key CPVs to monitor are:
2) gross margin
5) accounts receivable
Starting with inventory and accounts receivable representing the bottom two lines in the chart above, if you improve them (by reducing them), you will notice that your PBT doesn’t go up at all. “Inventory and accounts receivable have a gigantic impact on cash but a very small impact on profit,” Bates says. “If we have a cash problem, I can focus on inventory and AR, but if I have a profit problem, I’ve got to focus somewhere else.”
The next line up from bottom of the chart is sales. A nice driver, but not as steep as the final two, due to variable expenses lessening their positive impact.
The line above sales is expenses. As seen on the chart, a 10% reduction (improvement) in expenses puts more money on the company’s bottom line and creates a bigger PBT than does 10% more in sales. However, Bates notes, it says nothing about a corresponding impact on market share or employee motivation to cut expenses, which may be extremely lacking.
The top line on the chart represents gross margin. “It is the single biggest driver of profitability that we have,” says Bates. “When we start talking about improving profits, we’re going to have to talk about getting more margin, controlling expenses and also driving more sales.”
The Price Cut Temptation
Once a distribution company has their benchmarking data and a basic understanding of profit variables, it is necessary to recognize the commonly made mistakes that still follow, thanks to human nature, Bates says. One of the biggest, he says, is price cutting.
The chart at the bottom of p.8 in the white section, “The Increase in Unit Sales Required to Exactly Offset a Price Reduction,” illustrates for a company with $500,000 PBT like Mountain View, for every 1% price cut represented across the X axis, the company will have to increase unit sales — not dollars — by the corresponding percentage represented on the Y axis. For example, a 5% price cut needs 30% more unit activity or roughly 35% more dollar volume. “This exhibit says, for the overwhelming majority of distributors, you cannot make it up with volume. But we tend to cut price whenever there’s a recession,” says Bates. “When they’re not buying, they’re not buying. To what extent you can use a price cut to drive volume, my guess is if you drive more volume, you’re going to have people who are your customers loading up on the lower price and then not buying when things get back to normal.”
What happens when suppliers are the ones to cut prices first? One way a distributor can try to mitigate the impact of a supplier price cut is through the economics of price adjustments by velocity code. Break your product line into A’s, B’s, C’s and D’s, Bates recommends.
- A’s are tonnage items, probably about 60% of your sales volume. They tend to be commodities.
- B’s are basic items, good, nice solid items, 20% of sales.
- C’s are slow sellers, 15% of sales.
- D’s are really slow specialty items, 5% of sales.
If your competition cuts price 5% but you only lower the price of the competitive A category, in order to maintain your gross margin percentage (25% for Mountain View) you would still have to raise the B’s 5%, raise the C’s 6.7% and the D’s 20%.
The Trade Off Between Cash and Profit
The second issue with regard to mistakes distributors might make is failing to understand the tradeoff between cash and profit. What does it mean to collect faster? There are eight factors to consider, using the Mountain View distributor example:
1) Collections per day = $54,795
2) Collection period goal = 36.5 days
3) Accounts receivable goal (No. 1 multiplied by No. 2) = $2 million
4) New collection period goal. Cut the AR by five days to collect five days faster. (With a gigantic assumption that the same sales volume will remain the same, Bates notes.) = 31.5 days
5) New accounts receivable goal (No. 1 multiplied by No. 4) = $1,726,027
6) Reduction in accounts receivable (No. 5 minus No. 3) = $273,973 of AR freed up and turned into cash.
7) Carrying cost (interest, handling, bad debts, etc.) = 8%
8) Profit impact (No. 6 multiplied by No. 7) = $21,918
As noted in part 1, Mountain View only had $200,000 of cash to begin with. While cutting the collection period does frees up a lot of cash, the profit is only up by just under $22,000. The distributor is making $500,000 and only improved by $22,000. But, Bates says, you have to look at the implication on the sales side.
To measure the break-even point for a sales decline, you need to take fixed expenses, $3.5 million for Mountain View (noted in part 1), and add in the profit of $500,000. Then, subtract how much profit is generated by cutting the collection period, $21,918. Divide that number by gross margin percentage, 25%, minus variable expense percentage, 5%. “We’re trying to ask ourselves, how much would sales have to go down before we wipe out what we just made?,” Bates says.
The formula looks like this:
Fixed Expenses + Current Profit – Gain from Collections
Gross Margin % – Variable Expense %
The answer in this example is -0.5%. What it says is, cutting the collection period five days without reducing sales at all is equivalent to five-tenths of a sales loss. Put another way, if sales go down one half of one percent, it would wipe out five days of improving the collection period. “This is your trade off and you need to understand it,” Bates says.
Cash Versus Profit for Inventory Planning
The last mistake distributors tend to make in a down economy is to stop buying. “That is a kiss of death. I’m going to argue long and hard against stopping buying,” Bates says.
An argument can be made to raise inventory or lessen inventory in order to drive profit. The higher your inventory, the better your fill rate, the more you can provide customer service. But at the same time, distributors who are trying to achieve financial stability cannot afford to be overstocked, Bates says.
While the fill rate or the service level is “almost impossible to measure,” Bates notes it is easy to measure inventory turnover. In a down market, cash is king, so the lower inventory argument tends to win out. Still, Bates argues, “Don’t stop buying.”
Why? Because people buy from you because you have something they want. Whenever customers are asked in any line of trade what they want from their distributors, the responses are the same, according to Bates. In order of importance, customers will say:
- I want a great fill rate. I want you to have stuff when I need it because I actually needed it three days ago.
- I want depth of assortment. I want one-stop shopping.
- I want speed of delivery because I did forget to order it three days ago.
- I’d like you to actually send me what I ordered — order accuracy.
- And a price would be nice.
“If I stop buying, the first thing I run out of is the good stuff. Ideally, what we’d like to do is get rid of the bad stuff. There’s a recession going on. Nobody’s buying good stuff, much less bad stuff,” Bates says. “Try to hold the line to the extent that you can on the inventory. If you can slowly get it down, that’s great. But no ‘stop-buying edicts.’”
In part 3, coming in the June 10 issue of Premium, Bates will address an action plan to improve long-term financial performance in order to position your company for long-term success. Read part 1 here.