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Introduction & Diagnostic Phase
Businesses grow and evolve over time. Some go from strength to strength. Others maintain steady and discreet positions. Quite a few go under. A business going under does not usually happen overnight. It can be a long-drawn-out affair, which at some stage becomes inevitable.
Dramatising the process is to compare it to watching a train crash in slow motion. Whatever caused the train to derail is usually a series of related events, which resulted in the crash. Possibly none of these events singularly would have lead to the crash. However, combined they were lethal.
Nevertheless, a business failure is not unavoidable. There are plenty of warning signs along the route. If due note had been taken then there might have been a different story.
This does not mean the key people involved were reckless or unaware of what was happening as it unfolded. More likely explanation is that at some stage the situation had got beyond them although they probably did not realise this then.
However, the purpose of this article and a follow on (Implementation & Road to Recovery) is to outline ways to avoid the unavoidable failure. Many executives faced with such a turnaround situation are initially overwhelmed by the array of problems facing them. The question is where to start and what are the priorities.
First and foremost is to identify the "causes" and the related "symptoms "which are dragging down the business. Many of the problems are in fact symptoms and their solution lie in properly identifying and tackling the causes.
Pit Stop - Cash Flow
The primary focus for uncovering what is dragging down the business and causing serious haemorrhaging lies in the financials. The first reaction is to start out analysing the trading results and working out from there. Nevertheless, many businesses even with reasonable trading results are in difficulties. In my experience the best overall indicator of the financial health of a business is its cash flow.
Cash flow is the lifeblood of any business. Even unprofitable businesses can continue to trade for a long period provided they are generating positive cash flow. On the other hand a profitable business can grind to a halt rapidly with negative cash flow.
What is the principal drain on the cash flow? Is it trading results, working capital, acquisitions, other investments or activities? The situation did not happen overnight so looking back over the last 3 years is a useful exercise. This will iron out any temporary distortions to give a representative trend on where the cash is going.
Putting priority on cash flow from the beginning ensures the solutions must be focused also on maintaining sufficient cash flow. The future cash flows will give the time and space to address the issues. I will come back to this later in the articles but it is fundamental the cash flow concept is continuously present in our thinking.
The cash flow analysis will flag the areas that are draining cash. However, in my experience it is rare there is one compelling cause for the problems facing the business. The more likely causes are series of events and issues, possibly individually insignificant, which on aggregate are a serious financial haemorrhage.
Therefore, armed with the cash flow results the next step is a diagnostic of the business to dig deeper and reveal the causes of the problems facing the business.
The primary focus is what is dragging down the business. What is causing the red ink to spread over its trading results or its financial position? Where is the financial haemorrhage and how can it be stopped.
We need to look at the business from different angles to get a comprehensive view of its situation and the causes of its problems.
- Business Model
- Funding Model
This focus should not be muddied with steps to improve the business in the future. These are separate issues and will have their place in the overall strategy but later.
Finally, the purpose of a diagnostic is to get to grips with the big numbers and issues. Digging down into the detail at every stage will not normally change the overall preliminary conclusions. Time is a scarce commodity in a business turnaround situation and the lack of it may strangle even the best plans and strategies.
To demonstrate some of the concepts I have included some illustrative financial statements as Exhibits. The purpose is to mimic the effect across the financial statements of certain business decisions.
- Business Model
The cash flow analysis may have already flagged trading results (EBIDTA) as a drain on cash. Many of the principal causes are usually found in the business model.
Business models come in all shapes and formats. Nevertheless, they have a common thread; how does the company make its money? In simplistic terms, a company sells it goods or services to earn a sufficient commercial margin to absorb the indirect costs and generate a net positive result (EBIDTA).
While this appears obvious, it may not be the situation today in the company. Cost increases may have overtaken selling prices eating into the commercial margin. Indirect costs may also have increased further deteriorating results.
As stated previously we are looking for causes that are pulling down the business.
Revenue Model and Sales Issues
Declining or stagnant sales are clear markers of problems. However, an expanding sales situation can also contain a myriad of problems but not attract the same attention.
A key factor here is associating the sales evolution with any decline in the commercial margin. Digging down into the detail will likely throw up some commercial actions, which provoked a downward trend in the commercial margins.
Pricing, rebates, discounts, customer type, and returns policy are the potential conflict areas. How do these compare with competitors? How have changes in sales conditions affected commercial margins. The core sales business may be sound and the problems maybe in new business, markets and product launches.
The root cause may be in generating sales at any cost without realising the toll this was having on the financial results and cash flow.
Costs and Commercial Margins
Does the company have a competitive cost structure? Is this cost structure in line with its sales revenue model? Many companies want to have a certain revenue model but resist changing the cost model. A budget airline cannot have the same cost structure as a regular carrier.
However, the most frequent cause of deterioration in the commercial margin is the inability to pass on cost increases completely to customers. Often this has been a corrosive effect happening over several years. Perhaps the real extent of the damage was not fully understood as no one year stood out.
We need to find out whether rising costs have eroded the commercial margin. A 3-year history of the principal product costs evolution linked with their sales price evolution over the same period will usually reveal the trend and the major causes.
Is the indirect cost structure aligned with the current business or is it a legacy from the past.
GM still leads the US auto market with 19% market share. The top 4 auto makers are in the 14- 19 % bracket. In market share GM is among its peers However, GM still has a cost structure more suitable to its glorious past than its current circumstances. GM problems in this respect are not confined to itself or the auto sector.
However, the legacy issue is more associated with large drop in demand and the inability to drop the overhead costs in the same proportion. In many businesses, the causes are not so clear-cut
We need to look at the overall evolution in the overhead costs. When overhead cost increases outpace the sales growth in sales then this is going to depress results. Once again this may have been discreet, happening over several years, as discussed above under costs. Overhead costs often have an insidious nature. No particular element may stick out. However, many are for external services containing inbuilt annual increases based on fixed agreements.
The key question is what damage excessive overhead costs are causing the business in its current circumstances. An easy rule of thumb for these purposes is to consider any percentage cost increase above the 3-year average sales growth as excessive.
Following this approach it is possible to determine the principal causes for the worsening in trading results and their partial impact on cash flow. However, trading activities have added cash flow implications (working capital) beyond the trading results. These are analysed under the financial model.
In Exhibit 1 below, sales have increased by 3% over 3 years. We have assumed that while nominal price increase were higher discounts have reduced the overall increase
Costs prices and Overheads are assumed to have increased by 6 and 8,5% over 3 years because of normal inflationary increases. However, Trading Results have dropped by a whopping 20% over the period. This is because of the leverage effect these have on results.
As I mentioned previously the real extent of the damage caused by not fully recovering costs increases is often not realised. While the figures and percentages quoted are only for illustrative purposes, they do tally with many real-life situations based on my experience.
The problem areas are normally found in excessive assets or liabilities when related to the type and level of activity of the business.
The principal balance sheet areas are the following
Debtors, Stocks, Creditors, Other Receivables, and Payables generated by the trading activities.
On an overall basis how do the principal components (Debtors, Stocks, Creditors) compare with the sector. What procedures are in place for managing working capital levels? Have Working Capitals levels grown in excess of the sales growth?
The typical causes for excessive growth in Working Capital levels are usually linked back to decisions taken in trading activities. Sales growth facilitated by extended customer credit terms. Lower material costs obtained through larger orders resulting in higher stock levels.
While these decisions may have benefited the trading results, they have put additional pressure on the ongoing cash flow situation. Some businesses have healthy trading positions but are under financial stress because of excessive working capital needs.
Finally, poor management of working capital may also be a contributory cause.
Capital Investments and Other Investments
The first question is whether the productive assets are suitable for the type and nature of the business. Are the production levels suitable for the trading activities? What damage is any suboptimisation causing the business in its current circumstances?
Is there anything unusual within the liabilities unrelated to the normal business activities?
- Funding Model
The financial model for most business are based on three principal areas which although interrelated have individual financing needs.
The daily and ongoing activities of the business.
Debtors, Stocks, Creditors, Other Receivables, and Payables generated by the trading activities.
Capital and Other Investments
Capital Investments (Plant, Buildings, Machinery)) and Other Assets needed to support the trading activities.
Financing or funding these areas can be organised through various methods. The general rule is that trading activities and working capital are funded by short-term debt and capital and other long-term investments with long-term debt and shareholder funds.
Financial stress is generated by changing this composition. Many companies have faced problems by ignoring this distinction. These may have arisen because of operational reasons or other investment decisions and some examples follow.
- Trading Losses
- Excessive Working Capital needs
- Short-term debt financing long-term activities
- Excessive leverage between short and long-term debt and shareholder funds.
- Bad or Illiquid investments in other businesses or activities unrelated to the core business.
- Poor cash management
- Servicing financial costs and loan repayments on debt structure.
Some businesses for strategic reasons may decide to carry a higher working capital to penetrate a market. Other businesses have decided to invest in futuristic state of the art technology. In each case there were sound business reasons for the decisions.
However, financing these may not have not been organised in a satisfactory manner. Higher debt leverage at low interest rates may have turned sour because of unforeseen interest rate increases. Flexible balloon loan repayments now a problem as cash flows failed to rise as expected with the new investment. Low interest foreign currency loans converted into a financial nightmare when capital repayments are ratcheted up by currency depreciation.
The key question is to what extent the financial model is putting undue stress on the business. Irregular or poor cash flow can be a problem even for profitable businesses.
The following is the evolution of the balance sheet .
In the exhibit working capital has doubled over 3 years while sales remained almost flat. The business has used all its positive cash flow in working capital.
The long-term implications in this case are serious. This is the typical scenario, where to preserve sales customer credit conditions are significantly loosened. The risk of bad debts and unsaleable stocks has increased substantially. This is laying the seeds for the tipping point for the business in many cases.
The fact the business is in difficulties must question the credibility of the current management. They knew the crisis facing the business and its problems. Undoubtedly, they tried various courses of action to address the situation and perhaps with some success in some areas.
We will come back later to address their overall performance. At this stage, our prime interest is whether management took some momentous or strategic decision that subsequently led to the problems currently faced by the business.
Examples are management led initiatives driving significant product launches, new markets, new technologies. Failures can derail a previously sound business.
However, the explanation may be more mundane and prosaic. The more common cause is just bad managers. This only became obvious when the business conditions got tough and exposed their professional inadequacies.
Most businesses have diverse groups of stakeholders. In general I define them as influence groups that can bring more or less pressure to bear on the business.
The more conventional are shareholders, customers, creditors, banks, suppliers, income tax and social security authorities, and employees.
Stakeholders' interests do not necessarily coincide with the best interests of the business. In the particular circumstances are any of these exercising more pressure than normal on the business because of their own problems or criteria.
Benefits and pension packages negotiated by heavily unionised employees may favour the employee but strangle the business. The US auto manufacturers are examples.
Excessive dividend payments pay-outs depleting the cash reserves.
However, often the causes are routine. Dominant customers getting excessive discounts and credit conditions are more common
Preliminary Conclusions – Diagnostic Phase
The purpose of the diagnostic is to get to grips with the big numbers and issues causing its financial haemorrhaging. It should be kept as close as possible to the actual business, its immediate environment and its short-term future.
There is a tendency to get ahead of oneself and look out at the broader issues such as market evolution, technological changes and future opportunities. There is another time for these.
The overriding concern is to get the business back on an even keel. To do this the focus must be kept on the business avoiding distractions on issues, which are contextual but are not the immediate causes of the current problems.
There is also the time factor. A firefighters' priority is to put out the blaze as soon as possible. He cannot afford to take time-out meanwhile to consider how the building should look when rebuilt.
Therefore, we need to focus on laying out the principal fault lines hitting the business and their causes. Secondly, we need to prioritise them.
In the illustration we have been using the conclusions would be as follows.
- Funding – Working Capital out of control with a high risk of significant bad debts and unsaleable inventory. This could put the business future seriously at risk if this continues unchecked. Immediate action needed on receivables collections. Business is running out of cash.
- Business Model- Commercial sales policy causing low sales growth. Non-recovery of cost increases causing big drop in results. Profits are still been achieved but serious damage is being caused.
- Management - losing control on sales policies and working capital.
Some readers may consider the illustrated business is only having trading problems and has not reached a truly distressed condition. However, I mentioned in the introduction that a business failure it is comparable to watching a train crash in slow motion.
So I have rolled forward the figures forward in the illustration over the following 2 years if no action was taken.
The business has incurred losses principally because of bad debts and stock write-offs. The cash position has become unsustainable. The business has reached the tipping point. Unless financial support can be urgently obtained, it will fail.
I mentioned earlier that cash flow is the best indicator of the health of a business. At the end of year 3 the cash flow was already red flagging a serious problem whereas from a trading prospective the business was still profitable
This is all only an illustration. However, this scenario is played out daily in the real business world. The numbers causes and circumstances are different but the result is the same, another business failure. Nevertheless, it can be avoided with fewer painful consequences through a timely intervention.
Based on the preliminary conclusions the next step to put together an action plan. This is developed under a follow on article titled
- Implementation and Road to Recovery.
Here we develop ideas for working out an action plan to address the most immediate issues, map out a future strategy for the business and the necessary steps, timelines and benchmarks to achieve the goals and targets that have been determined and feasible in the circumstances.
Finally, it is important to maintain a fluid communication at all times with all the important stakeholders and act in accordance with the terms of our mandate.
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