Ideas & Stories

Smart Owner Part 3: Why Cash is King

Chris in warehouse

A few years back, we were helping a client manage a merger with a bigger organisation. Our client was well run, had tight housekeeping and their accounts were impeccable. They were justifiably concerned about their new merger partner’s balance sheet. Massive work-in-progress, unbilled jobs and uncollected debts.

Unconcerned and dismissive about the concerns raised by our client, the merger talks soon collapsed. Six months later, we heard that the potential partner was in serious financial trouble. Our client knew long before the other people did.

Why is it that some business owners look at their Stock, Debtors and WIP as though it is “money in the bank”? Why do they get it so wrong and what can they do to fix it?

1. Stock

What is the right amount of stock?

How can a clothing reseller meet the needs of every prospective customer if she doesn’t have every size, colour and style of every product in her range at every retail site that she runs? Hard. What happens at the planned (or sudden) end to a season when all that is left are the unpopular styles in the outlying sizes and colours?

Yes, you say, that’s what twice-yearly sales are for. To attempt to recover some of the cost of over stocking… before scrapping the rest. And potentially damaging the brand through discounting.

Wine manufacturers get caught in a dilemma when their current vintage doesn’t completely sell. The next vintage is happily growing in the sun and soon needs to be picked. Do they discount their current vintage? Do they dump it through on-line sale merchants and risk damaging their brand? (Check out how bad it got for Treasury Wine Estates).

Brand suffers when you discount.

Over the years we have come across some horrible stock problems. The profit and loss account still show profitable trading, and that’s good. But a careful look at the balance sheet reveals massive stock levels. Coincidentally, the bank manager has just said ‘no’ to their most recent overdraft extension.

In many of these situations, unsold stock got pushed to the back of the warehouse. Out of sight, out of mind. Other slow-moving stock remained just that. Until it got slower and ultimately stopped too. New stock is still needed to meet demand. No-one really notices. The business still seems to be out-of-stock of regular lines and suppliers are putting the business on credit-hold. And the warehouse is full?

All this time, the stock remains recorded at full value. Which is why the Profit and Loss Account looked fine. But a quick comparison of the stock recorded in the balance sheet against the levels of sales, holds the key. Stock turnover against any benchmark is way too slow. Of course, as some lines never sell, and other lines sell many times over, it may be worse than it seems.

Businesses need a stock strategy. Rules about age and turnover.

This is another ‘black-art’ skill for the owner. And good record-keeping and stock statistics become a handy tool. The skill comes from the ability to predict the amount of sales for every stock line for the forthcoming time period. It needs to consider; the amount to be maintained in stock, the need to close out a line at the end of a season, the lead times for supply and resupply, reorder quantities and the prediction of which lines are likely to be most popular.

And every business owner gets that prediction wrong to some extent. Some stock lines will not behave as predicted.

The trick is to manage the error and managing it early. If something is not selling, adjust your thinking. Change the minimum order quantities, cancel standing orders and don’t make the problem worse. Next, deal with the problem. What do you need to do to move this stock? Is it merchandising? Is it marketing? Does it warrant a discount? Could you be clever and package it together with a full priced line?

Check what the leaders in your (or similar) industries do to manage their stock levels and wastage. You might be surprised at the clever and resourceful techniques adopted. One thing is sure… if they are good at it then someone is driving this hard.

2. Debtors (a true story)

Many years ago, we employed our first Debtors Clerk. Frankly, at the time, I could not see why we needed one. Surely that was a waste of money?

Turns out we had two collection problems.

The first problem we knew about. Our (then) partners at our (then) practice would bill their clients based on what time had been spent on the client’s affairs by the various members of their team. Partners didn’t like billing so that task was delayed as much as possible. They didn’t like it because very often, the clients received a surprise for all the work that was done.

So, those annoyed clients sometimes did not pay.

The unpaid bill sat there getting older and older. Time continues to elapse and eventually, the client doesn’t remember the work that was done. Even if the work can be justified, it is now way too remote. There is a problem looming. And it is the partner’s problem and they are not doing much about it.

The first (initially huge) task for our Debtors Clerk was to take stock of all outstanding issues and set about resolving the problems, one by one.

The second task was to stop that problem list ever growing again. Our new debtors’ clerk was very experienced. She had worked for a finance company. At her previous job, 14 days meant 14 days. She would call them on the 15th day. She would very politely ask for payment. She was very good at it.

But a call on the 15th day. Should we do this too? Could we? After all, we were Chartered Accountants not some finance company. But she insisted.

What happened?

It was amazing. And the outcome was not what we expected.

Yes, clients accepted that they had to pay on time, after all, the terms were stated on the invoice. But the real magic was for those clients who had received invoices that they were not expecting. Our Clerk would take the matter straight to the Partner. She would set a program for resolution and expect that within a few days the matter would be resolved.

As it was. And paid soon after.

But here is the thing. Eventually the partners worked out that the best way to avoid the query from the client would be to talk to them before they send the invoice. In time, they worked out to talk to the client before they did the work. The clients felt far more in control and their needs were met in a much better way.

We had happier clients, our debtors’ problems disappeared, and I learned a valuable lesson. Thanks Carol.

Managing debtors requires a two-pronged approach. Firstly, don’t be distracted by only managing the problem debtors. Secondly, be methodical and insistent about your credit terms. 14 days means 14 days. Call them on day 15. Nicely.

3. WIP

WIP takes many forms, such as jobs in process in the factory, construction projects awaiting the next progress invoice or simply the time spent on a professional services matter that is yet to be billed. Valuable work has been done.

The ability for a business to bill for the work that remains incomplete will depend on the industry and the terms of the contract with the customer or client. Clearly, the tighter the contract, the greater the ability to minimise the total unbilled amount.

Unfortunately, many businesses do not track WIP in the financial reports, even if tracked through separate job or time recording systems. And what is not in the accounts becomes easy to forget and easy to ignore.

And just like Debtors, the older a balance becomes, the likelihood of collection shrinks. The link between the work (especially variations) and billing become too distant and the justification gets harder. There is a greater and greater chance that more and more of that WIP will get written off.

Good business hygiene requires business owners to treat WIP as potential Cash.

It needs to be carefully measured and properly controlled. Aging analysis of balances and comparing to benchmarks can help identify problem accounts, jobs, matters, teams or fee earners. Some professional firms go so far as to hold back income of practitioners for amounts of WIP (and Debtor) balances over agreed benchmarks. That usually gets action from the persons responsible.

Properly managed and controlled, WIP can turn into invoices, and then into cash. But if neglected, it is like setting fire to money.

These three balance sheet items of Stock, Debtors and WIP all represent the unavoidable working capital requirements of most businesses. They also represent a key area where the diligence of the owner in the hygiene factors of their business are most critical.

Which is why we (regularly) say:

Growth is vanity
Profit is sanity, but
Cash is king

Chris Alp
Business Specialist Partner