We are not turnaround specialists. Regardless, we are occasionally asked by intermediaries to intervene with a business in financial distress. Before accepting such an assignment, we ask ourselves, “Will CPR work for this business, or is it too late?”
The answer almost always comes down to cash flow. With a troubled business, little else matters. If the business can be improved to produce enough cash flow to work out of the problem, applying CPR makes sense. If not, it is time to order embalming fluid.
Why cash flow? Cash flow is the lifeblood of the business. Further, projected future cash flow is the single biggest driver of the price a sophisticated buyer is willing to pay for a business. Cash flow drives value.
Improving cash flow
We typically start rehabilitation projects with benchmarking. If the business is a member of a trade organization, typically there is industry-specific benchmarking data available. Otherwise, other generic sources are available from places such as the Risk Management Association (RMA).
We use the benchmarking to compare the client’s financial ratios and key metrics to other businesses of similar size and industry. Identifying the data for which the client is in the bottom quartile, or bottom half, helps identify the areas within the business that can produce near-term improvement in cash flow.
With the benchmarking data, we typically find four areas that can be addressed by cash-starved businesses. But since cash flow drives business value, even healthy businesses should consider some attention to these four areas on a regular basis.
Businesses in financial distress typically slash overhead, often in the form of across the board cuts. While reducing overhead is necessary for a troubled business, care should be exercised to avoid cutting into muscle or bone. Cuts to marketing can damage revenue growth at a time when additional revenue may be needed to work out of the problem. Mandatory pay cuts, especially in the current job market, can cause an unwanted loss of talent. Excessive or misdirected overhead cuts can further damage the business.
However, regular control of overhead is good business hygiene, even for a healthy company. We worked with the owner of a profitable, growing manufacturing business who conducted a head count on the first of each month. He believed his business required three employees producing goods or services to support the budget for every nonproduction or overhead employee. So, no new “overhead” position could be filled unless there was sufficient growth to add three new production personnel.
Often, financially troubled businesses attempt to grow themselves out of the problem. This is an admirable goal. The challenge is how to grow sales. If marketing and sales resources are downsized through overhead cuts, growth could be a challenge.
If the strategy is to cut prices to attract more sales, will competitors match those cuts to retain their customers? If so, that strategy may only result in reducing prices to the current customers without the expected increase in total sales, and thus it may compound the cash flow problem.
If the strategy is to chase new revenue with new products or services, or in new markets, a cash strapped business will not likely have the necessary cash flow to cover the required investment.
We once worked with a client who was pursuing an opportunity with a potential new customer that would have nearly doubled his sales. Due to declining cash flow, his bank was reluctant to increase his credit line. We were asked to help him work through a cash-flow forecast. Turns out the incremental net operating profit on the new business would be just under 3% of sales, which would only modestly boost profits. But the 60-day terms required by the new customer would have essentially put him out of business due to negative cash flow.
Growth is important, but it must be strategic and profitable growth. Every business, regardless of health, should project the impact of growth not only on profit, but also on cash flow.
Cash-starved businesses often overlook the opportunity to improve cash flow by improving gross margin.
A business can increase gross profit by increasing its selling prices. Yes, business owners fear losing customers. But if gross profit is at 50 percent, a 10 percent increase in prices means you can lose 17 percent of your customers and be no worse off.
A business can improve gross profit by eliminating sales discounting. Using the same example as above, at the same gross profit of 50 percent, if you discount your prices by 10 percent, you need a 25 percent increase in sales just to maintain. The exception, of course, is slow-moving or unpopular (never-moving) inventory, which should be immediately discounted to convert the inventory to cash.
Shorten cash operating cycle
Perhaps the biggest short-term “bang for the buck” is the opportunity to shorten the cash operating cycle. This is the number of days required between paying for purchases, converting the inputs to product, selling them and collecting from customers. It is calculated using the average of days costs in inventory plus days sales in accounts receivable minus the average number of days in accounts payable.
If your accounts receivable averages 47 days and the days in inventory averages 31 days, and number of days in accounts payable is 25, your cash operating cycle is 53 days. Simple math of 47 plus 31 minus 25.
Shorten the cycle and cash flow improves. It improves by faster collections from customers, gaining better prices or terms from suppliers, maintaining leaner “just in time” inventory levels or some combination of all three.
In conclusion, we remind every business owner, whether cash strapped or healthy, that the eventual buyer of your business will set the price based primarily on the cash flow of the business. So, start benchmarking, manage your overhead, only grow strategically, improve gross profit and shorten your cash operating cycle.