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In the current economic environment, firms
are placing much more emphasis on financial integrity than ever before.
However, the vast majority of potential actions are ones that should
have been taken before a recession hits. It proves almost impossible to
strengthen balance sheets, for example, when sales and profits are
sliding.
In addition, some of the actions taken to strengthen the firm are
proving to be counter-productive. For example, enhancing the firm’s cash
position frequently, comes at the expense of profitability.
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This report will examine the issue of
financial integrity. That means the ability to survive an economic
downturn with a minimum of pain. The report will also suggest that the
lessons of this recession should not be forgotten amidst the euphoria of
the eventual recovery. The report is organized into two key sections:
Things To Do in the Future—This section will provide a checklist
of key ratios to monitor that will ensure the firm faces the most
minimal financial turbulence possible under any economic conditions.
Things Not To Do Now—This will
provide a cautionary road map to actions that should be avoided at
present.
Things To Do in the Future
There are a lot of ratios that firms should review to make sure they are
prepared for economic challenges in the future. The four most important
of these are reviewed in Exhibit 1. These include 1) Debt to Equity, 2)
Defensive Interval, 3) Cash to Current Liabilities and 4) the Break-even
Point. These ratios were chosen because they are best suited to help the
firm maintain a strong banking relationship, offset sales declines and
position the firm for growth when economic conditions improve.
The first column of numbers in Exhibit 1
presents suggestions for an appropriate result for each ratio. It should
be noted that these guidelines are conservative. These are the results
that will keep firms out of financial trouble except under the direst
economic conditions. The second column of numbers presents results for
the typical AVDA member based upon the latest PROFIT Report. Column
three is simply the difference between the first two columns and
represents any potential gaps that must be closed.
Debt to Equity—This is the classic banker’s measurement of a
firm’s financial philosophy. The lower the figure, the more conservative
the firm. It is calculated by dividing total liabilities (all
obligations of any kind, including accounts payable, notes payable and
the like) by total equity (net worth). The historical banker’s goal for
debt to equity is 1.0.
In good economic times firms tend to increase their debt to equity ratio
in an effort to grow the business as fast as possible using outside
financing. In bad economic times firms tend to die in reverse debt to
equity order. In the future firms would be well advised to maintain a
1.0 level and avoid the widely discussed “excessive exuberance.” This
will most likely involve reinvesting a sizeable portion of future
profits back in to the business.
Defensive Interval—This is a classic “little used and little
understood” ratio. It is calculated by dividing total operating expenses
(excluding depreciation) by 365 to determine the cash expenses that must
be met each day. This figure is then divided into cash to determine how
many days the firm can operate if sales and collections fall all the way
to zero.
Clearly, this ratio measures a worst-case scenario. However, it provides
some very strategic insights into the firm’s ability to withstand a
sudden jolt in terms of sales and collections. Ideally, this ratio
should be at least 15 days. The two alternatives to improve this result
are to increase cash balances or to lower operating expenses,
particularly payroll.
Cash to Current Liabilities—This is the most stringent test of
the ability of the firm to meet its short-term obligations with existing
cash balances. It is calculated by dividing cash by total current
liabilities (largely accounts payable and short-term notes payable).
This ratio examines how well the firm is able to continue to pay
suppliers and other creditors (as opposed to operating expenses) without
an additional infusion of cash. To be truly conservative with cash, this
ratio should be around 20.0%. Again, there are two improvement
paths—increase cash or lower short-term debt. One of the real mistakes
that many firms made in the period of steady growth was to finance sales
growth through short-term financing.
Break-even Point—This is the level to which sales can drop before
profit falls to zero. Since every AVDA member has a different level of
sales, this measure is presented as a percentage of current annual
sales. Ideally, the break-even point should be no more than 80.0% of
current sales. That is, the firm should be able to experience a 20.0%
sales decline before profits are eliminated.
Lowering the break-even point requires two parallel efforts. The first
is to enhance the gross margin percentage so that the firm gets paid for
what it does. The second is to gain tighter control over operating
expenses.
Things Not To Do Now
Sadly, the list of things not to do is very similar to the list of
things that most firms are currently doing. Of these, two are the most
strategic.
Don’t Lower the Investment in Inventory and Accounts Receivable—Cash
may be king, but converting inventory and accounts receivable to cash is
not just a bad move, it is often a disastrous one. Lowering inventory
almost always involves a “stop buying” edict. The firm immediately runs
out of good inventory. Accounts receivable is often subject to a similar
line of thinking. Lowering either of these will drive sales down even
further.
Don’t Sell Out the Future—The break-even point needs to be
lowered. However, anything that is associated with sales generation
should be cut only if the situation is desperate. Too many firms reduce
their marketing expenditures only to find that when the market begins to
turn up, they have lost all of their visibility to potential customers.
Cuts may be unavoidable, but they should be made only to the degree that
is absolutely necessary for survival.
Moving Forward
The good news is that the recession will end; possibly even faster than
most economists think. The bad news is that old habits die hard. Firms
will forget about financial integrity in a bid for sales growth. When
the next downturn comes too many firms will inevitably repeat the
mistakes of this recession.
It is a cycle that only enriches profitability/financial consultants,
such as the author of this report. It is a cycle that must be broken.
About the Author: Dr. Albert D. Bates is founder and president
of Profit Planning Group, a distribution research firm headquartered in
Boulder, Colorado.
©2009 Profit Planning Group. AVDA has unlimited duplication rights for
this manuscript. Further, members may duplicate this report for their
internal use in any way desired. Duplication by any other organization
in any manner is strictly prohibited.
A
Managerial Sidebar: Calculating the Break-even Point
Break-even analysis is one of the most useful measurements that firms
have in their financial tool kit. However, very few firms actually
utilize the break-even point in their financial planning, largely
because of uncertainty as to how it is calculated.
The following example should assist in the calculation. All of the
figures presented are for a typical AVDA member currently generating
$250,000,000 in sales. As can be seen, the formula requires knowing only
three things:
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Gross Margin %—Gross margin dollars as
a percent of sales volume.
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Fixed Expenses—Fixed expenses for the
year, expressed in dollars.
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Variable Expenses %—Variable expenses
expressed as a percent of sales volume.
If the firm is unsure about the relative
mix of fixed and variable expenses, a useful approximation is that about
80.0% of total expenses are fixed and everything else is variable. The
formula is not overly with regard to assumptions about fixed and
variable expenses. As long as the breakout is reasonable, the formula
will provide an accurate answer.
As can be seen, the typical AVDA member, with current sales of
$250,000,000, has a break-even point of 39,500,000. This is equal to
87.8% of current sales, which means the firm can experience a sales
decline of 12.2% before profits are eliminated.
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