Written by:
Michael Burdette
Company Secretaries are one of the most underutilised resources in business today. They are usually well-qualified people who can and would be wiling to become involved in the process of ‘adding value’ to the company not just to perform compliance and due diligence roles. This article is written to empower these talented individuals to be included at a far more productive level in business.
Recently I was a guest speaker at a business forum and was asked the question, ‘We experienced over 400% growth last year and now have severe cash flow problems. This doesn’t make sense, surely with such a huge increase in sales and increased profits we should have plenty of surplus cash?’
This situation is very common with companies in their ‘adolescent cycle’. To answer this question we need to investigate a few issues. The first question to really consider is what is growth
Is growth simply an increase in sales? Is growth an increase in profit? Is growth a combination of both?
The best way of demonstrating this is graphically.
In the example we have used values rather than percentages. The trend line (Linear profit) is included as it is difficult to determine that the profit is trending down.
What difference would it make if we looked at profit as a percentage of sales, rather than a ‘cold’ value?
In this example the trend line is steeper and indicates the company is headed for troubled times.
This is a typical case of ‘Blind Growth’. The company has grown sales dramatically, but at the expense of profit. It is a common occurrence in the commercial world, and of course, as the company runs out of cash, there is a mad scramble to secure a bank loan of some description. One can hardly blame the banks for getting tough and invariably rejecting the application unless unrealistic values of ‘bricks and mortar’ security can be offered. (In some cases up to three times the loan value)
Let’s have a look (at this example company) to find what happens to cash in the last two years of June 05 and June 06.
From June 04 to June 06, this company has almost doubled sales. At what cost to cash has this happened?
In this example, the cash position has decreased by almost 8,000,000. This table demonstrates the sales growth they have achieved, required almost 4, 000,000 in additional funds. This is a typical scenario where profit is too low, debtors are too high and we have assumed they carry no stock!
Their cash position is now in danger of sending them into receivership.
Notice how much better the profit is in this table. For June 05 and June 06, let’s investigate the impact on cash flow, for this scenario.
The Cash position looks considerably better in this case, although they still need an additional 255,000 to pay all there debts. Whilst not advisable, they would have a better chance of securing a loan to compensate for the shortfall in cash. The cells in green indicate where the profit improvement was achieved, namely, in lower wages and lower costs, resulting in lower creditors. Note too that we have included the corporate tax in our calculations. The down side of making more money is that we pay more tax.
It is a total nonsense when executives say, ‘I keep my profit low in order to minimise tax’. This is not only a recipe for disaster it is also irresponsible. The simple facts are that unless you make a decent profit, you will experience cash problems. So don’t expect any ‘compassion’ from your accountant, the tax department or the banks.
Doesn’t this present a good picture? In this Scenario, the company has plenty of cash, has huge potential for buyouts, and captures more market share. Debtor days in this scenario have been reduced to 35 days instead of 70 days. The profit has been kept the same as for scenario 2.
It is important to note that in order to keep the examples simple we have not included stock in these three tables. Stock turns, however, would have an impact on growth potential too. The higher the stock turns the better it will reflect on your cash flow.
Referring back to the beginning of this article, the answer to the question asked at the forum would be, ‘It is most probable that your company has grown sales at the expense of profit, compounded by poor debt and stock management.’
Before embarking on any growth strategy a number of factors need to be considered.
Profit is critical to healthy cash flow. Anything under 10% profit (before tax) as a percentage of sales is the first sign NOT to grow sales. In fact a PBT (profit before tax) of 15% or higher is desirable. If your profit is below 10% then FIRST get your company in order before entering into sales growth. So effectively, introduce a ‘profit growth program’ before a sales growth program.
Some typical areas to investigate how to improve profit are;
Bad debtor management is the most common area of mismanagement. Debtor days should be between 30 to 45 days. In some industries (such as Automotive, Publishing and supplying to Government departments), this is not possible. If you are in an industry, where it is not possible to get debtor days down to 30 to 45, then the only way to compensate for this is with increased profit. In addition, you need to manage your costs, marketing and fixed costs accordingly.
What debtor days of say 70 means is that you are financing your client for 70 days, whilst you still have to pay wages, creditors, taxes and utilities, before recovering their money.
There are no excuses for poor Stock turns. It is simply poor management. Stock turns of less than 4 is an unacceptable position and it will always be difficult to maintain good cash flow. In addition to that the higher your stock turns are, the more likely it is that you will write off more stock at the end of the financial year, further eroding your profit and cash position. Stock turns of four, translated means that you turn over your stock, on average, every three months.
This is another neglected area of management in most companies. The fixed and variable costs determine your ‘Break Even’ point in the company. The more sales you need to break even the lower your profit and consequently the lower your cash position. Fixed costs are a danger trap. The higher you’re fixed costs the more difficult it will be to have good profits, no matter how efficiently you run the company. Fixed costs should be limited to 25% of sales.
So many companies today are ‘hoarders’ in that they hold onto all the assets they have. If an asset is not being used or used efficiently, sell it. For all value adding assets, there should be a regular review of each asset’s break-even point. If an asset is not earning its worth, sell it.
A good example of what NOT to do is one of the largest computer software companies in the world turnover lap top computers every 18 months or so. The old ones are either thrown into cupboards, or taken home by staff for the kids to use. If you consider that perhaps this company dumps 30,000 computers, each year, globally, that would equate to approximately $1,000,000 annually of wasted cash flow funds.
We have now demonstrated the issues surrounding ‘blind sales growth’ but is there a tool available for managers and executives to determine should we ‘grow our sales’, and if growing sales is not advisable, what needs to be done so that we can.
As an analyst, I love finding consistent patterns that figures play in the world of solving business problems. Once again I wasn’t let down by my beloved figure analysis. The one ratio that delivers a consistent measure as to whether or not we can indulge in sales growth is the ‘Burdette Cash Ratio’. To calculate this ratio you need the following information,
That’s it!
By opening cash balance, we mean, that if you have an overdraft or bank loan in place then by all means use it. The same applies for an available closing balance.
The calculation is
Burdette Cash Ratio = (Opening Balance – Closing Balance) ÷ Profit Before Tax
This is best demonstrated with an example.
What does this all mean? Looking at a graph may help.
What this demonstrates is that if your Burdette Cash Ratio is greater than 0 (zero) then you need to look at some issues BEFORE embarking on a sales growth program. The higher the number the greater the risk.
If your figure is a NEGATIVE number, you are safe to embark on a PLANNED sales growth strategy.
The Burdette Cash Ratio is only useful as a quick check to determine ‘should we grow sales’ or not. The Burdette Growth Matrix has been developed as a simple but unique tool to help point you in the right direction as far as what needs to be addressed before developing a sales growth strategy.
The important message in this article is:
If you are to GROW anything make sure you GROW, Sales, Profit AND Cash Flow Simultaneously.
This simple matrix is easy to use and pinpoints where you stand in terms of growth. To use this matrix find the point of intersection of;
There is an example of using the matrix following, the quadrant descriptions
This is where you want to be. If your points are in this quadrant, you have no problem in growing sales, profit and cash, providing growth is planned, profit percentage maintained and all the other contributing factors are managed.
This Quadrant indicates that your Burdette Cash Ratio and Profit percentage are on track, however, you have debtor and/or stock turn issues to resolve.
Synopses – fix the issues and enjoy good planned growth
This Quadrant, whilst indicates some serious issues regarding profit and/or cash it does show that debtors and/or stock turns are managed well.
Synopsis – Get your profit and cash sorted out, this will take time. Don’t favour sales growth!
This quadrant is the very worst position you could be in. Everything is a mess.
Synopsis – GET HELP FAST and possibly new MANAGEMENT
Example of Using the Burdette Growth Matrix
In the green quadrant the points intersect at Debtor days = 51 days and %profit = 17%
In the Blue quadrant the points intersect at Stock turns = 5 and Burdette Cash Ratio = -0.02
In this example, this company is not far away from developing a ‘growth’ program. The debtors need some attention, however, the Burdette Cash Ratio, the percentage profit and stock turns are all excellent.
This article will no doubt help readers to understand the mechanics of growth and how to pin point the issues surrounding growth. Solving some of the problems raised in this article will not always be easy, however, if it were all too easy there would be a lot more billionaires in the world. Besides, if that was easy we would have no need for Managers, Accountants and Company secretaries.
Michael Burdette is the author of the Analysis Book ‘Contemplate Your Business Navel’, which has been selected for the Dymocks Book Lovers Club. Michael engages in many speaking assignments around the world as guest speaker and develops simple high-powered tools for businesses(internationally) to use. Visit his website at www.burdetteanalysis.com.au for business tools and www.bookbiz.com.au for the book.