When I was in grad school, one of my business classes showed a flowchart diagram that identified three major causes of business financial failure: low gross margin, inadequate net operating income, and excessive leverage. The picture showed causes and effects of each of these major factors. It also identified how all these items are interconnected. In the end it was a large web with the poisonous spider of business failure lording over the structure. Unfortunately, many business owners do not have the ability to escape from the web when they are trapped in it. If they could, they may be able to save their business instead of succumbing to the financial poison of failure.
A few years ago, I met with a business owner that had been on my problem loan list for several years. They had made several moves to improve their business, but were still struggling. I shared with him the financial spreads with industry comparisons for his business over lunch one day. There we identified all three major causes of business financial failure, which happened to be present in his company. It was my goal to help free him from becoming another statistic.
The first main factor of business financial failure is low gross margin. The company had worked hard to build his client base, but had done sacrificing profit for business growth. They focused only at the top line revenue. The cause of the problem was inadequate pricing and high cost of goods sold (COGS). The poor gross margin did not leave enough money for them to pay their operational expenses, thus a shrinking NOI. To survive, they had to borrow more funds, putting too much leverage in the company. They were losing money but were going to make up for it with higher volume! (If you don’t make enough money for your product, selling more of it will only make the problem worse and not better.) In this case, the gross margin was over 25% lower than the lowest quartile of the industry.
The owners learned to adequately price their work. They installed minimum pricing standards and walked away from jobs that did not meet their requirements. They also learned to not take low margin jobs in an attempt to build future business. This construction company found that they chased after fewer jobs and the ones they pursued they were able to devote more time, performing the work at a higher standard and more profitably.
The next major problem the company had was a negative NOI. Causes of this began with the inadequate gross margin. Other factors were operating and interest expenses were too high for the company. The negative NOI required more money that had to be injected from the owners and additional, poorly structured borrowing. The additional borrowing increased interest expenses, making the problem worse.
The company had too many employees for their work. Any owner hates to let people go, but if you can’t do something profitably, and do not have the ability to print money when you need more of it, you will eventually not be able to employ anyone at all. My client also had kept excessive equipment, which had ongoing maintenance costs. They began to sell equipment they did not use on a regular basis. This not only reduced maintenance expense, but also reduced some of the principal of the debt they used to fund the equipment.
The third major problem was the high leverage. The industry average was a debt/equity ratio of 3.5:1. This company was close to 14:1. The company needed equity and they needed it quick!
The cause of the equity drought was from several factors. First, excessive losses from poorly priced and jobs where they were not paid had eroded away their equity. The next factor was increased borrowing. The increased leverage and decreased equity took the company to a point of insolvency. The expenses to maintain the debt also ate into cash flow, forcing the company to shuffle bills around and work payment plans for their accounts payable.
The solution came from two sources. First, the owners raised money in from their family to put into the business as equity. The increased equity injection did not cause any loss or control for the owners. Next, the company identified a division of the company that was profitable, but also cost time and resources from their core business. They sold the division, retired some of the debt, and put the rest of the money into equity. This reduced the debt/equity of the company down to 2.8:1.
My last meeting with the owners came into a term loan review less than a year after all these changes were put in place. We visited in the company conference room. The company president leaned across the table and said, “Phil, we have a new problem with our company. We don’t know what to do with all the excess money we have!” The company was retiring debt at an accelerated pace, began to match employees contributions into the profit sharing fund, and, built a cash reserve of several months of all operating expenses.
The job I had as a trusted financial advisor was complete. The owners had freed the company from a web of financial failure. I also won a bet I made with my head credit administrator that the company could survive.--Phil Love