Dr. Al Bates
President, Profit Planning Group
Boulder, Colorado

“So this EASA member walks into a bank and asks for a loan.” Well, there’s no need to wait for the punch line as it is no laughing matter. In many cases, the credit available to members has all but dried up. Where money is available, banking require­ments are becoming more restrictive almost every day. The likelihood of things getting better any time soon is remote.

With enough patience and concert­ed effort, the cash challenge associated with disappearing lines of credit can be overcome by rethinking gross mar­gin and expense levels even during a recession. In fact, this will be the topic of the next Profit Improvement Report.  However, many distributors need cash now, not in six months. The conclusion is that inventory and accounts receiv­able reductions are in order.

The reality is that most of the ac­tions typically taken to lower invest­ment levels are cash positive in the short run and dangerously profit negative in the long run. Given the multiple effects of cash generation pro­grams, EASA members need to take a step back and rethink their investment levels in some different ways.

This report will examine two very different approaches to reducing the investment levels in accounts receiv­able and inventory:

• Chopping—An immediate reduction in investment levels to generate cash as quickly as pos­sible.   
• Pruning—A more gradual ap­proach to investment reductions, but one that does not create long-term profit problems.

Chopping
Time to state the obvious; chopping is something of a pejorative. However, in extreme circumstances it may be the only alternative. The problem is that it is often applied even when there are other alternatives available. Very serious thought and care needs to be employed when adopting this strategy.

To fully understand the impact of this approach, it is first necessary to review where the typical EASA firm stands.  Exhibit 1 provides a financial overview of this typical firm based upon the most recent Operating Per­formance Report. The first column in the exhibit reflects results before the current economic challenges. 

This firm generates $3,250,000 in revenue, resulting in a pre-tax profit of $130,000, or 4.0% of sales. Generat­ing this level of performance requires an investment of $400,000 in accounts receivable and $300,000 in inventory.

Like every firm in every industry, this typical firm has both fixed ex­penses and variable expenses. Fixed expenses are overhead expenses that tend to be difficult to shed as sales fall and fall directly with sales. These have been estimated to be 7.5% of sales. According to the Operating Perfor­mance Report, these figures are rea­sonably close to most EASA members.
The last column reflects the impact of a 5% reduction in both accounts re­ceivable and inventory. As can be seen at the bottom of the exhibit, with the 5% reduction in these categories, a total of $35,000 is converted into cash. It pro­vides the firm with substantial breath­ing room from a cash-flow perspective.

The challenge is that even with reductions as small as 5%, there is the likelihood of a sales decline because of the reduction in investment levels. If accounts receivable collections are tightened sharply and credit limits are lowered, sales suffer almost automati­cally. On the inventory side, the firm essentially places limits on the amount of merchandise that can be ordered. The result here is that the firm runs out of stock on key items quickly. Again, sales will suffer.

If sales decline by 5% (simply one of many potential scenarios), then pre-tax profit falls by $56,063. Assuming a 30% tax rate, the after-tax profit decline is $39,244. It needs to be noted that the $35,000 conversion of inventory and accounts receivable to cash is a one-time event while the decline in profit after taxes of $39,244 is an every-year problem. It could even be worse as being out of stock eventually creates serious customer-satisfaction issues.

There are also some other poten­tially negative effects from chopping that cannot be adequately quantified. An inventory reduction will neces­sitate ordering in smaller quantities. This could cause the firm to lose some order-quantity discounts. Ordering in smaller quantities also means more fre­quent ordering that increases receiving and stocking costs.

The case for chopping is much stron­ger if sales have already declined. In this case the firm is responding to a deterio­rating situation. Even here, though, caution is in order. Investment reductions, particu­larly with regard to inventory, almost al­ways cause a further deterioration in sales volume. If for exam­ple, sales decline by 10% and inventory is cut by the same 10%, sales will almost cer­tainly fall ever further because of the inven­tory reduction.

Pruning
Time to add an­other arcane term to the profitability vo­cabulary. In pruning the inventory, firms need to “de-deadify” the inventory. This means a focus only on dead inventory in an intense effort to eliminate items that have not reg­istered meaningful sales activity over the last year.  

Clearly, such inventory generates no sales volume. Converting the inventory to cash would not reduce the firm’s service level in any way. It is as close to a pure cash opportunity as exists today. 
The challenge, of course, is that nobody wants to buy the dead inven­tory or it wouldn’t be dead in the first place. This has caused most firms to ignore the pruning opportunity. How­ever, through a combination of deep discounting, active promotion and simply dumping some inventory for a tax credit, substantial improvement is possible.

If the firm could eliminate 10% of its inventory, that is a reduction of $30,000.  Since such merchandise is unlikely to generate more than 50% of its cost in discounted sales, the potential cash conversion is around $15,000. It is not an inconsequential change given that it should not come at the expense of a sales decline.

Another downside to pruning is the time frame involved. A concerted de-deadifying project will take anywhere from three to six months to complete. In order for the project to be successful, somebody must be responsible for the process during that time. The entire firm must support the effort.

Moving forward
When lines of credit dry up, chang­es in investment levels are almost inevitable.  If at all possible, such reductions should be driven through pruning rather than chopping.  The long-term sales and profit challenge is eliminated with this approach.  

However, for firms with serious issues regarding cash flow, there may be no alternative to chopping.  When contemplating such a drastic strategy, though, it is essential to be fully in­formed of the consequences. Unless planned properly, serious profit reduc­tions will follow. 

Categories: Technical topics

Tags: Profitability

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