Avoiding burnt fingers

 

With the plethora of companies coming to the market much focus is being placed on EBITDA– earnings before interest taxes dividends and amortisation.

EBITDA has increasingly become the key metric to show the "intrinsic operational performance" of the business, i.e., the performance when all costs that do not occur in the normal course of business (e.g., restructuring costs, ramp-up costs, consulting fees for special projects, special legal fees) are ignored. While this is helpful in general, it is often misused by declaring too many cost items as "one-offs" and thus boosting profitability.

Many of the companies have as yet only traded at a loss and based on their history, there is no basis for concluding that these unprofitable companies will ever make money.

That’s the stock in trade for a company about to float whilst losing money. If it were making a profit before its IPO, it would be harder to make bullish forecasts about how much profit the company will generate in the future.

Ironically for a company losing money, the sky’s the limit when it comes to predicting how bright its future revenues will be.

In tandem with the ability to forecast a spectacularly profitable future is the functioning of one of the market’s most basic laws: momentum. In other words powered by its own performance a stock that is gaining value up will continue to appreciate in value just because it is going up.

More specifically, when there is no real positive cash flows on which to value a stock, its price will rise because investors who do not own the shares will want to climb aboard the bandwagon rather than miss out.

This wave of “new buying” can help to drive up the shares further, which will attract a new buyers creating a dangerous bubble.

It would probably be a more prudent strategy to avoid the money-losing IPOs and invest in companies who are making a profit before they try and float their shares.

However forecasting the price of stocks remains an inexact science and unfortunately for the investor there is as yet no failsafe basis on which to explain why stocks go up and down.

Effective stock control

For suppliers and manufacturing companies alike the efficient management of stock is a vital element of their business.

In many cases business failures can be traced back to the inability of a company to turn its stock back into cash within an acceptable time frame.

It is worth noting the costs associated with carrying stock:

Holding stock ties up working capital with otherwise could be used for other purposes therefore it has an opportunity cost.

All stock being held incurs storage costs such as rent and other utilities. Insurance especially for high value goods also is an expensive add-on.

If goods are being funded via a Bank overdraft or loan this may well inhibit the company’s ability to finance other activities as Banks are reluctant to extend terms.

There is always the danger that stock can become obsolescent or in the case of perishable products deteriorate and become a write off.

The only way to ensure that a company keeps track of this area of exposure is by constant monitoring of stock levels and focussing on unusual or irregular patterns in the movement of stock.

 

Charity begins at home

 

There is a growing pressure on suppliers to accept extended payment terms if they wish to retain the business.

Companies who previously had accepted 30 day payment terms are now requesting periods of up to 90 days.

Such terms can only be served by larger organisations with adequate cash reserves. For the small to medium supplier it further ratchets up the pressure at a time when banks are unwilling to increase their credit lines.

It has been general commercial practise for companies to try to stretch the length of their payment terms by all manner of means both fair and foul.

However as profit margins are further squeezed by increased operating costs the importance of maintaining cash flow is vital.

Business is hard-won in the current climate, but above all there has to be a commercial raison d’être for any transaction.

Mutual reciprocity has to be the basis for the Customer/Supplier relationship for it to remain worthwhile.

 

Tesco - every little helps

 

The fallout from the revelation that Tesco had been overstating their profits has and will continue to be immense. Following their mea culpa on Monday the market responded with a sell-off which wiped £2 billion off of the value of the company.

The scenario has become all too familiar over recent years. Companies seemingly enjoying a never ending run of profits and nobody willing or prepared to ask the difficult some might say obvious questions.

The initial statement referred to accounting errors in the previous 6 months which then raised questions about the validity and integrity of previous results.

In the only course of action open to the management of Tesco they launched an independent enquiry. This will not only focus on the role of Tesco senior management but also their auditors of long standing Messrs PWC.

How many times has the scenario played out? Loose governance, directors preoccupied with their own bonus structure, Auditors not getting to grips with the fundamental issues of the business they are auditing.

Either the figures are wrong through incompetence or deliberate falsification it can only be one of these two issues.

In smaller companies it is not unusual for management under pressure to resort to “massaging the figures” whilst unacceptable business practice it does not have the implications that accompany the Tesco situation.

The damage to shareholder confidence and the brand itself is incalculable. It will be difficult to rebuild trust from either the market of its customers with the overhanging feeling that there may well be more skeletons lurking in the cupboard.

Don't neglect stock control

Efficient stock control can limit the effects of problems in the supply chain whilst at the same time reduce the amount of capital which is being tied up with excessive stock.

Many companies have adopted the “just in time” ordering policy and as a result have little or no buffer stock.

Whilst this does translate to a reduction in working capital and lower storage costs there are potential problems such as the inability to deal with an unexpected spike in demand.

This policy also means that the purchasing company has little control and is therefore reliant on the efficiency of its suppliers.

The other side of the coin is to maintain a relatively high level of stock holding which ensures that the company never runs out of material and may afford some economies of scale by bulk buying.

As with all things it comes down to a judgement call.

The best measure is stock turnover ratio equals cost of goods sold during a specific time frame, divided by the average stock holding during the period.

The result of this ratio gives the "number of days that on average money is tied up in stocks". The longer this is, obviously the worse this is for the business as the money is not available to be used elsewhere.

An stock turnover ratio of 20 means that the average amount of stock holding during the year has been renewed, or turned over, 20 times over the course of the year.

Dividing the number of days in the period under consideration by the turnover ratio tells you how many days it takes, on average, for the warehouse to empty and then be refilled. The number of days in a year, 365, divided by 20 is 18.25. So the entire stock is fully sold and replenished every 18.5 days, on average.

As a general rule, the higher the stock turnover ratio, the more efficient and profitable the firm. A high ratio means that the firm is holding a low level of average inventory in relation to sales.

 

Never underestimate the value of the human touch

Technology continues to revolutionise the way in which we do business. Business practises have changed markedly in recent years and will continue to do so.

Although many operations are completed electronically in this virtual world we should never forget that essentially commerce is about people trading together.

The reality of the real world is that goods need to be moved from point of production to point of consumption and obviously the diverse elements which make up this chain cannot be achieved solely via a computer terminal.

It makes sound economic sense to foster and maintain good customer relationships.

It has been determined that it costs up to five times as much to win a new customer as it does to retain one.

There is an old adage “know your customer,” this dictate has never been more important than in these competitive times.

 

Wake up call

 

The demise of the telephone company Phones 4U illustrates some harsh truths about operating in today’s business climate.

To the outside world the company appeared to be a successful entity. At the time of going into administration the company had a turnover of over £1bn, EBITDA of £105m for 2013 and significant cash in the bank.'

However a closer scrutiny of the company showed it was heavily burdened with debt and reliant on its suppliers to ensure its long term survival.

Once Phones 4U lost the support of their suppliers they were essentially finished. Without product to sell there was no business.

Although a rather extreme example it does highlight the need for companies to acknowledge that it is a two way street. Notwithstanding the importance of the buyer (end consumer) it is paramount that dealings with suppliers are maintained on a fair and equitable basis.

Many companies rely on operating on a “just in time basis” which can leave them particularly vulnerable if there is any disruption to the supply chain.

For any business relationship to grow there has to be mutual reciprocity and understanding of the other party’s situation.

Be it constant delay in payment or unreasonable requests it is not surprising that suppliers decide that some business accounts aren’t worth the candle. When a supplier decides that enough is enough there is not always a readymade alternative