December 2003              return to newsletter contents page

Where Will You Be in Five Years?

by Albert D. Bates

Profit Planning Group

From a profitability perspective, 2002 was the worst year in memory for most distribution organizations.  AVDA members were not exempt from the profitability challenges.  In 2003 the typical return on assets (ROA) in the industry was 8.9%. ROA is pre-tax profit expressed as a percent of total assets.  The 8.9% rate scarcely justifies re-investing in the business for future growth.

While the typical firm has struggled, a few firms have enjoyed strong profitability levels. For 2002, the top-

performing group of AVDA members had an ROA of 11.2%, a profitability level that was 1.3 times the results for the typical firm.  In short, the industry has become two-tiered. That is, a lot of firms produce modest profits and just a few produce strong results. 

The disparity between typical and high-profit results should serve as a warning for typical firms.  While very few firms are sanguine about the profitability gap, they frequently do view it as the inevitable result of a stagnant economy.  The feeling is that as the economy improves, the rising tide will lift all ships.

A look at recent results and some realistic projections regarding the future suggests that economic recovery alone will not close the profit gap.  Instead, the disparity between winners and losers may continue to the point that it challenges the very existence of some firms.

This article reviews the longer-term impact of a two-tiered industry.  It does so by looking at two specific issues: 

• A Five-Year Projection—Most firms are not fully aware of the extent to which differences in current performance multiply over time and result in significantly larger differences in only a few years.  This section will examine just how important the difference between typical and high-profit really is from a growth perspective.

• The Improvement Challenge—Moving from typical to high-profit performance calls for improved results on several key measures.  Surprisingly, the magnitude of the required changes is not large.  However, changes need to be made in several areas of the firm simultaneously.  This section will examine the factors to be targeted for performance enhancement.

A Five-Year Sales and Profit Projection

Theoretically, every firm can grow as fast as it can find customers.  While sales growth may require an increased investment in inventory and accounts receivable, that investment can be financed through additional debt.  In reality, though, the availability of capital for growth rests upon the ability of the firm to produce a profit and reinvest that profit back in the business.  High-profit firms possess a pronounced advantage in the quest for capital. 

Exhibit 1 compares the current financial performance for two equal-sized AVDA members—one typical and one high profit.  At present the high-profit firm produces higher profits, which gives it a short-term advantage.  In addition, the exhibit looks at the two firms five years hence when the advantage has been dramatically multiplied. 

In order to address the impact of profit on growth, the exhibit makes a key assumption about profit reinvestment.  Specifically, the exhibit assumes that both firms reinvest all of their after-tax profits back in the business.  It also assumes that the firms continue to operate as profitability and as productively in the future as they do today. 

Both assumptions can be challenged.  After all, recessions do eventually end.  When this one does, the typical firm certainly will do better, but so will the high-profit firm.  As long as there are two tiers of results, the high-profit firms will always have an advantage.  This is true in good times and bad.

The exhibit suggests that the short-term advantages are magnified in the long term.  By the fifth year, the high-profit AVDA member has increased its sales by 31.1% using only internally generated funds.  At the same time, the typical firm can only grow by 34.9%.  Over time, the high-profit firm is not only increasingly successful in generating profits, but is also more successful in building a stronger market position.

Again, the typical firm could borrow the additional funds required to maintain sales parity with the high-profit firm.  Ultimately, that strategy will fail, for two important reasons.  First, an increasing percentage of profits must be used to pay interest charges and an increasing percentage of the cash flow produced by those profits must go to pay back loans.  Second, debt eventually becomes so large that there are simply no more lines of credit available to the firm, even from the most aggressive lenders.

In short, the difference between typical and high-profit results is important today.  Of much greater consequence, it is critical in the future.  Firms must commit to making the journey from typical to high-profit.  The question is how?

The Improvement Challenge

In most firms there is a prevailing perspective that if profit is going to be improved substantially, then the firm must make some dramatic changes in its operations.  In motivational guru parlance, it must commit to 1,000% improvements.  In fact, nothing could be further from the truth.  For several years, Profit Planning Group has espoused the philosophy that small changes in some key areas of the business can produce big results.

The latest AVDA PROFIT report identifies the factors that drive higher performance.  While nobody does better on everything, high-profit firms have two important advantages, listed in order of importance:

• Gross Margin Percentage—The high-profit firm produces a gross margin of 25.4%, compared to only 22.6% for the typical firm.  This is a gap which can be closed in two to three years.

• Inventory Turnover—The high-profit firm turns its inventory 5.4 times per while, the typical firm achieves a turnover rate of only 5.2 times.

These factors must be central to the planning activities of every AVDA member.  Every one on the management team must be focused on these factors.  They must also be fully trained on how these factors impact results.  Finally, every employee must be aware of the specific actions required that will lead to improvement on the key factors.

Moving Forward

High-profit firms have an important profitability advantage over the typical firm today.  If the performance differences continue, the high-profit firm will have an insurmountable advantage in the future.  The typical AVDA member must start today to close the profit gap.

Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2003 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 Note on Calculating Future Asset and Sales Levels

Unless the firm borrows money, the only capital available for growing the business is the after-tax profit that is reinvested back in the business.  For the typical firm, that figure was $1,890,000 in 2002.  When this is combined with the existing asset investment of $30,303,030, the firm produces a new asset base of $32,193,030.  This new figure can then support higher sales.

The typical AVDA member has an asset turnover ratio of:

Net Sales

Total Assets

=

$100,000,000

$30,303,030

=

 3.3

This means that every $1.00 of assets can support $3.30 of sales.  If this relationship continues in the future, then the new asset base of $32,193,030 can support sales of ########## ($32,193,030 times 3.3).  Subsequent years produce the same increase in sales generated by more assets which are, in turn, dependent upon increased profits.