Magazine article Management Today

Turn Down That Order

Magazine article Management Today

Turn Down That Order

Article excerpt

Question: how can a business with a full order book go bust? Answer: when it is over-trading. Robert Outram looks at ways to grow while minimising the risk

You have worked so hard to grow your business and now the biggest order you have ever had comes in. The order promises to hike your turnover by 30%. That has to be good news - so why is your accountant looking worried?

It may be because rapid growth, without the working capital to underpin it, can be anything but a godsend. Profit margins can be hit and the company's cash can disappear into a black hole. In the extreme, the business could go under.

Steve Hill, a corporate recovery partner with audit firm Coopers & Lybrand, has seen more than his fair share of corporate casualties: 'I have lost count of the number of times I've heard a company director saying, "How can my business go bust when I've got a full order book?"'

Over-trading, where a business incurs short-term costs it cannot meet while in pursuit of growth, is a classic problem which is almost always one of working capital. A survey of the chief concerns of SMEs, commissioned by International Factors, found that cash-flow was number one by a long way. Concern about markets and demand came far down the list.

Growth can really eat up working capital. Take the above example: if turnover goes up by 30%, so will direct costs such as raw materials, labour, subcontractors and power. For the typical business, many of these costs will have to be paid some time before any return can be expected from the customer. A big order at a 10% profit margin will typically mean increasing borrowings by 90% of the value of the order until the customer pays. If the orders keep coming, the borrowings keep rising.

Overheads can also go up. For example, extra premises might be needed and more administrative staff may have to be hired. All of this puts pressure on margins. As Terry Smith, a broker with City firm Collins Stewart argues when capital assets, stock and debtors are rising rapidly but cash-flow is weakening, it is time to hesitate: sales are vanity, profits are sanity.

Smith cites both natural cosmetics chain the Body Shop and frozen food retailer Iceland as examples where phenomenal growth was soon followed by an equally steep fail in profit margins. On some counts, both businesses continued to perform as stars, but impressive sales figures could not compensate for slackening profits, with the race for growth giving way to a policy of consolidation.

Large, listed companies are, of course, far less likely to collapse simply through overtrading. They have access to the finance which smaller companies don't and management systems in place to spot the problem in time. But even among the big boys, rapid growth can exacerbate any related problems. One example is Sterling Publishing, best known as the publisher of Debrett's Peerage. Sterling's core reference books business found a ready market in eastern Europe in the early '90s: turnover for the region went up by 65% to [pounds]32.3 million. Much of the revenue came from the advertising the reference books carried, which was generally not paid for until publication. The problem was that many advertisers did not pay at all or waited for anything up to 18 months after publication. Between 1993/94 and 1994/95 the group turned a [pounds]7-million profit into a loss of [pounds]8.4 million. Of course, the firm had made bad-debt provisions, but as ever had erred on the side of optimism. Over hasty growth into an untested market meant that what could have a been a local difficulty drove Sterling's share price to a low of 2.0p.

Niche retailer Sock Shop provides another sobering example. An enormously successful share issue in 1987 was followed by rapid expansion throughout the UK and into the US. Sock Shop, which ran its own stores rather than franchising them, splashed out heavily on new outlets in markets which turned out to be wrong for the company's idiosyncratic approach. …

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