Right now most businesses in the world of IT sales and distribution are doing two things – trying to finish 2008 without going bust and planning to survive in 2009, if not actually thrive. Be they manufacturers, distributors, resellers, retailers or etailers, the realities of running the business under these dramatically changed conditions are the same. Cash is key to survival, but simply monitoring the bank account will not be sufficient. And if you are relying on one or more channel partners to be around for a while yet to achieve your sales objectives, you need to know how likely they are to succeed under the credit crunch. In this blog, I am going to set out a few indicators that will help you tell if your partners are likely to make it through 2009, and some things you can do to improve their chances.
Liquidity – what is it and why does it matter?
First things first, is the partner going to make it through 2008? That all depends on its liquidity and its vulnerability to the changes in its customers’ behaviour and that of the banks. Liquidity means simply that the business has enough cash flowing through the business that it can pay its bills as they fall due. Often the first bill that causes a crisis is the payroll, as there is no scope for negotiating extended terms with employees. This is especially true of people-based businesses such as VARs and higher value dealers. After that it’s the statutory payables such as payroll taxes, VAT and other taxes, because the authorities don’t usually negotiate.
How can you tell if a business has enough liquidity? It should have been running a normal balance sheet before the credit crunch took hold where its current assets (inventory, receivables and cash) were greater than its current liabilities (payables, current portion of loans and overdrafts). Now it is especially critical that this is true. In fact it’s better to use what is known as the acid test: receivables and cash must be greater than current liabilities. This is because the bills may need to be paid before the inventory can be cycled back into cash.
When the credit situation gets tough, the tough … ask for more credit
Next look at what happens if the game changes. Tesco, a leading retailer has just unilaterally changed its payment terms from 30 days to 60 days for its non-food suppliers. Any distributor or manufacturer doing business with Tesco now needs to finance that extra 30 days credit, which is costly (it will take another 11.7% of sales to recover the extra cost), but more importantly sucks cash out of the trading cycle. If you were doing $1m of business with Tesco, you would now need another $82,000 cash just to keep trading at the current volumes. For most distributors, only a few of its customers (usually retailers) have the power in its trading relationship to do that to them, but for many resellers, most of its customers may have the power to extend their credit taken, extending the cash-to cash cycle. How much strain can a business take? As a rough guide, most banks would have financed up to around 50% of the equity (share capital plus retained earnings) in the business. Today these limits are nearer 30% and often lower. You need to know how your partners stand in the power play with their customers in terms of being able to resist moves such as that made by Tesco. Instead of special pricing for deals, you may find the conversation will move to special credit for deals, enabling the dealer to pass the working capital burden to the vendor with the strongest balance sheet.
Having enough cash and working capital to cope with tightened credit and demanding customers is one thing, but what do the plans for 2009 look like? One of the key tests we apply to any business is to look at whether that partner is creating value or destroying it. This means comparing the operating profit of the business to the cost of the capital employed in the business. If operating profit is greater, management has created value and if operating profit is smaller, then management has destroyed value. This may have seemed to be a bit of accounting jargon before, but in these times of very scarce capital, it is the ultimate measure. For example, if a business has $100m capital employed, then at today’s real rates, it will be costing it at least 10% to have secured that capital from its sources (shareholders, banks etc). So the business must make $10m operating profit before it has created any value at all. Note how this is lot more challenging than simply establishing a net profit versus a loss. It relates the profit to the resources used in making that profit. The plans for any partner for 2009 need to show how it will create value if it is to have any real chance of doing more than just surviving.
What can you do to improve your partners’ chances?
You need to do a rough calculation – is your “business model inside” a net enabler or a net drag on your partner? By business model inside, we mean the business model of your products in terms of the profitability and working capital requirements as they pass through the partner. To do this, first compare the operating profit your partner makes on your products to its average: Are your gross margins higher or lower? Will your contribution to overheads be higher or lower? Would the partner net out with better operating margins (ie the net margin before interest costs) if it just sold your products? Let say its operating margin is normally 2% of sales but for your products it is only 1.5%.
Do the same for the working capital required. Let’s say that its normal working capital requirement is 75 days as it has to pay most suppliers on 10 or 15 days to secure competitive margins, but for your products its requirement is 50 days as it can take 30 days to pay you without penalty. And let’s assume your business is worth $1m of sales a year out of the partner’s total sales of $5m. Calculating Value created on your business:
Working capital required: $1m x 50 days/365 days = 137k
Apply 10% interest costs to the working capital of $137k = $13.7k
Operating profit: $1m x 1.5% = £15k
So the value created is $15k operating profit less the $13.7k cost of capital = $1.3k
Comparing this to the partner’s overall business model:
Working capital required: $5m x 75 days/365 days = 1,027k
Apply 10% interest costs to the working capital of $1,027k = $103k
Operating profit: $5m x 2% = £100k
So the value destroyed is $100k operating profit less the $103k cost of capital = $3k
In this example, you should be leveraging your better working capital profile to both grow your share of the partner’s business and to turn its value destroying model into a value creating one. If the partner does not do this, then it will probably begin to fail in 2009, as it will not be generating an acceptable return on its capital, putting its sources of capital at risk…and therefore its liquidity – something you know it cannot afford to do.
What should you be doing now?
Here’s a checklist of the topics should be covering in your next conversation with your partners:
- How are customers reacting to the credit crunch and general market conditions?
- Have credit limits from suppliers/distributors changed recently?
- How is the effect of these changes affecting the cash to cash cycle and liquidity within the business?
- What actions is the partner planning to take to respond in the short term?
- What role can you (as a strategic partner) play in these actions?
- How secure are its sources of funding for 2009 and what is likely to happen to its cost of capital?
- How does the net profitability on your lines compare with that of the partner’s overall business?
- How does the working capital cycle compare?
- What actions is the partner planning to take to improve these two elements of its business model in 2009?
- What role can you (as a strategic partner) play in these actions?