December 2009              return to newsletter contents page

Financial Trends in Distribution

by Dr. Albert D. Bates, President, Profit Planning Group

The accompanying set of exhibits provides an overview of financial trends in distribution between 2004 and 2008. It places special emphasis on the changes between 2007 and 2008.

The analysis covers forty different lines of trade in distribution. In developing such a macro-view of distribution, it is not possible to compare most financial ratios directly. For example, some industries have a high gross margin and accompanying high expenses, while others have a low gross margin and low expenses.

What is possible is to compare the direction and magnitude of change. The emphasis is on how much performance changed during the time period covered. The changes are highly instructional in analyzing current issues in distribution and in planning for future periods of economic uncertainty.

In most of the exhibits results for all of distribution are divided into three subgroups:

Industrial—Lines of trade in distribution that primarily service the factory floor or commercial facilities.

Construction—Lines of trade that primarily serve the construction trades.

Consumer—Lines of trade that sell consumer products or service businesses that sell to consumers.

Exhibit 1
The Trend in Return on Assets

Profitability results for 2008 demonstrated the continuation of a classic “up and over” pattern associated with end of strong growth years followed by entry in to recession. ROA was adequate for most distributors in 2007. However, performance declined for the second straight year.

When the recession officially started in December 2007, non-construction firms continued to enjoy reasonable financial performance. This continued through the third quarter of 2008 when the economy took its toll on almost every industry.

The exhibit looks at Return on Assets (ROA). This is the best overall measure of financial performance in distribution. The ratio is net profit before taxes (but after all expenses) expressed as a percentage of total assets. Total assets represents the total investment in the business.

For an individual line of trade, a median ROA of 5.0% is considered the absolute minimum level of performance. If ROA falls below that level, firms begin to give serious consideration to liquidation in order to re-deploy assets into higher-returning areas. In contrast, a median ROA of 10.0% in an individual line of trade is an indication of a strong, vibrant industry. For 2005 and 2006 distributors, in aggregate, were near the 10.0% range. By 2008 ROA had fallen back by one full percentage point.

Exhibit 2
Sales Growth by Segment

In 2008 the construction industries bore the brunt of the economic downturn. Nearly every construction-based distribution industry experienced a sales decline. The median results for this segment was a 2.3% decline.

Both the industrial and consumer segments experienced a sales increase. Again, though, not every industry in the segments had a sales increase. In addition, the overall rate of increase was below what is typically required to maintain desired profit performance.

An important final note is that growth was driven by performance in the first three quarters. Towards the end of 2008, sales growth turned to sales declines for the majority of distributors.

Exhibit 3
The Change in Gross Margin Percentage

Interestingly, gross margin percentages increased for most lines of trade in 2008, despite the troubled economy. The only exception is that the construction industries, in aggregate, experienced a minor gross margin decline.

The significance of the exhibit is reinforced by an examination of those lines of trade where sales actually declined for the year. This group includes most of construction lines of trade, and several in both industrial and consumer goods.

Of those lines of trade with declining sales, seventy percent actually enjoyed an increase in the gross margin percentage. This suggests that even in difficult times, gross margin opportunities exist. In point of fact, in a slow economy firms are more oriented towards using margin gains to offset sales declines. It is essential to avoid using the economy as an excuse for lowering margins.

Exhibit 4
The Change in Operating Expense Percentages

Any time sales growth declines, operating expenses as a percent of sales tend to increase. When sales growth is negative, operating increases in the operating expense percentage are almost inevitable. This was the classic pattern followed by the construction segment of distribution. The pattern was also duplicated in the consumer segment where sales continued to grow, but not at the spectacular rates seen in previous years. Industrial was the only segment where the operating expense percentage actually fell.

The difficulty with the sales to expenses relationship is that it is almost always impossible to lower expenses as fast as sales decline. While lowering payroll expenses can be accomplished quickly, other expenses involve issues such as renegotiating leases which are lengthy processes.

The unpleasant implication of this is that if the goal is to lower expenses at the same rate as sales, payroll has to be lowered at a faster rate than the sales decline. Some payroll reductions are obvious in this regard—such as eliminating contributions to 401(k) programs and increasing the co-pay on insurance programs. If the sales decline is prolonged, the only remaining action in payroll is a sharp reduction in staff.

Exhibit 5
The Change in Inventory Turnover

In 2008, for the second straight year, inventory turnover fell in every industry group. Going further, only two of the forty-two lines of trade covered by this report experienced an increase in turnover. For most firms the dramatic and sudden slow down in economic activity in the fourth quarter simply could not be translated into lower inventory levels.

Lowering inventory levels is arduous at best when sales are sluggish. It is easy to lower inventory levels on key items. For slower-selling items, though, inventory reductions are agonizingly slow. Lowering inventory on key items increases the out-of-stock rate and further exacerbates the sales decline. Keeping inventory on slower selling items creates a cash trap.

Inventory turnover plays only a minor role in driving profitability. However, it is a huge issue with regard to cash flow. The on-going decline in turnover is a major concern, particularly for highly leveraged firms.

Exhibit 6
The Change in the Average Collection Period

The collection period (the days sales outstanding) declined in two out of the three segments. The fact that the collection period was improving in light of slower growth is only slightly surprising. It also follows a trend that was started in 2007.

Typically, as sales growth lessens the collection period initially increases as customers take advantage of opportunities to delay payment. However, responses in accounts receivable can be made much quicker and much “easier” than can responses in inventory. Clearly, distributors were tightening credit policies. Faced with cash flow challenges and an inability to lower inventory levels quickly, cutting receivables may have been the only available course of action.

Reducing the collection period is potentially a very-sharp double edged sword. Obviously, collecting faster help improve the firm’s cash flow position. However, overly-aggressive cuts in the collection period may lead to lost sales.