The Financial Impact of Consolidation; Why Is It So Hard on Smaller Companies?

And it’s true. But why exactly? What are the specific changes in the financial operating environment of smaller companies that’s made life so difficult for them?

 

It’s 1993. The glory days when a snowboard company could sell all the decks it could get at full price if they could only find a competent manufacturer who would deliver on time (well, at least not too late) a quality (okay, reasonably decent) product. The mythical Burp Snowboard Company is on a role. The company did US$4 million in sales this year and its income statement looks like this for the 12 months ending 31 December 1993:

 

Net Sales                                  $4,000,000

Cost of Goods Sold                  $2,400,000

Gross Profit                              $1,600,000

 

Expenses:

Sales and Marketing                  $    400,000

Commissions                            $    280,000

General and Administrative        $    500,000

Interest and Miscellaneous         $    100,000

Total Expenses:                                    $ 1,280,000

 

Pretax Profit                             $    320,000

 

In 1993, snowboarding is a nice clean business. The balance sheet at the same date is a thing of beauty. There’s cash in the bank. Receivables are pretty low because a big chunk of sales were COD and terms, when offered, didn’t extend past 60 days. Product is flying off the retailers’ shelves, so retailers have paid you as agreed and bad debts are minimal.

 

Inventory? Not much more than what you think you need for warranty and some stickers and T-shirts. If you’re lucky, some samples for next season have already arrived.

 

Cash flow wasn’t great at the beginning of the season. But half of sales are to Japan and they paid for at least half their $1,200,000 order in advance. The rest showed up in the company’s bank account a few days after shipment. Your creditors (excluding some of your suppliers) are giving you terms of 30 to 60 days and retailers are paying you before you have to pay them. Snowboarding is so hot that raising a little money from some wealthy friends of friends was pretty easy. That and the money from Japan allowed you fund your operating expenses from January through July and to make required supplier payments.

 

Burp’s employees and you, the owner, are all thrilled to be in the snowboard business and are working your asses off for not too much money. Customer service, sales management and warranty are all pretty minimal expenses. Retailers and customers are just happy to get product and aren’t demanding much in return. You increased your prices 10% over last year and nobody so much as raised an eyebrow.

 

Ain’t life grand?

 

Fast forward to 31 December 1996.   Who knows what happened to Burp, but the New Guy snowboard company has also done US$4 million in the calendar year that has just ended. Their income statement looks like this:

 

Net Sales                                  $4,000,000

Cost of Goods Sold                  $2,720,000

Gross Profit                              $1,280,000

 

Expenses:

Sales and Marketing                  $    400,000

Commissions                            $    280,000

General and Administrative        $    500,000

Interest and Miscellaneous         $    100,000

Total Expenses:                                    $ 1,280,000

 

Pretax Profit                             $               0

 

The only change shown above is that the gross profit margin has been reduced by 8 percent from 40 to 32, reflecting competitive pressures and the resulting product pricing. In fact, as discussed below, you can also expect some increases in operating expenses.

 

Your balance sheet has changed from a thing of beauty to a nightmare. Cash is kind of scarce. Inventory isn’t. You’ve got a bunch of it left and it’s worth less by the day. If you sell it at all, you’ll be lucky to get your cost out of it. This is the result of order cancellations and over supply that has allowed retailers to buy product in season at great discounts (great for them anyway).

 

Your receivables look about as good as your inventory. Retailers have demanded terms with the result that, as of 31 December, a bunch of your receivables aren’t even due yet. Those that are due aren’t exactly coming in right on time, and some significant bad debt seems inevitable. Unless you’ve built up a hell of a bad debt reserve over the last couple of years, your pretax profit of $0.00 is going to be a loss if only because of collection problems.

 

Japanese orders were only a quarter of your total sales this year. The market there, and in the rest of the world, is moving towards more recognized and reliable brands from larger companies. There was no cash up front from the Japanese distributor and you felt fortunate to receive a letter of credit that got you paid within a week or two of shipment.

 

You had to sell more product units to achieve the same net sales due to price competition and as a result had to finance an additional $320,000 in cost of goods sold. Because of collection problems, you have to finance it for longer. Your suppliers, feeling some of the same competitive pressures you are feeling, helped out some by offering some better terms, but the net result of higher cost of goods sold and slower collections is more interest expense.

 

Administrative and selling costs have increased as retailers have demanded better warranty and customer service and reliable, timely delivery. You had to add a customer service person, offer point of purchase displays, and upgrade your computer hardware and software. You had to front your reps some more money so they could be every where they needed to be and look good being there. Shipping expenses increased as you worked hard to make sure everything got to the retailers on time.

 

You can’t just be an order taker anymore. Sales have to be earned and that means time and expense.

 

All these changes didn’t catch you completely by surprise. In order to adjust to them, you actually reduced your sales and marketing expenses by 25% during the season. Unfortunately, you did it at exactly the time you needed to spend more to establish your brand name. Your move made good tactical, short-term sense, but was a strategic error that will only make things more difficult in the future.

 

The net affect of all these changes, then, leaves you with an income statement for 1996 that probably looks something like what’s shown below.

 

Net Sales                                  $3,850,000

Cost of Goods Sold                  $2,720,000

Gross Profit                              $1,130,000

 

Expenses:

Sales and Marketing                  $    300,000

Commissions                            $    269,500

General and Administrative        $    600,000

Interest and Miscellaneous         $    150,000

Total Expenses:                                    $ 1,319,000

 

Pretax Profit (Loss)                   $(   189,000)

 

Not a pretty picture. I’ve assumed a five percent bad debt on the non-Japanese part of sales. Your cost of goods doesn’t decline because you don’t typically get that product back. Sales and marketing expenses are reduced by $100,000 though you really ought to be increasing them. Commissions are down a little to the extent net sales have declined. General and administrative expenses are up $100,000 to reflect the increased costs of doing business and an extra $50,000 in interest expense has been added.

 

A company similar to one that made $320,000 in 1993 has lost $189,000 in 1996. That’s a decline of 159 percent. Cash flow is critical as well and investors who were so accommodating in 1993 are reluctant to provide any additional financing in 1997 because they can’t see that the risk they would be taking is justified by the potential return. Prospects for orders for the 1997-98 season look bleak because retailers are turning to larger, more established suppliers.

 

What did the management of New Guy do wrong? Operationally, nothing. This is the result they would have achieved, and the position they would be in, if they did literally everything right. Their problem is that they didn’t have a well functioning crystal ball. They didn’t look into the future and see that industry maturity was inevitable and would require either that their company achieve critical mass before the consolidation began or have a distinctive competitive advantage.

 

It’s hard to be too tough on them for that, since most of our crystal balls don’t work to perfection either.

 

The industry shakeout isn’t going to reward only operating well. Of course you have to do that, but success under the new market conditions will ultimately depend on the strength of your balance sheet and having a clear competitive advantage and market position.