The business climate has been strong over the past year with notable data specific to manufacturing and export sectors hovering around three-year highs. The Institute for Supply Management’s manufacturing index in May climbed to 55.4, up from 54.9 in April, pushing it to the highest level since December 2013 (numbers above 50 indicate expanding factory activity). The Production Index jumped to 61.0 in May up from 55.7 in April, the highest reading since December 2013. Greater confidence about the business outlook in the U.S. has led to this expansion — a booming U.S. energy sector and rising overseas demand brightened the nation’s trade picture in late 2013, sharply boosting estimates for export growth in 2014.
As much as this growth potential is a welcome sight, it’s no mystery that companies experiencing rapid growth in sales can find themselves starved for cash. This phenomenon can affect all types of companies — mismanaged growth can lead to mounting debt, lost sales and eventual bankruptcy. Why is this so? How are some companies able to avoid this predicament and handle sales growth successfully, while others go out of business, never to be heard from again?
Some reasons for mismanaged growth are common to all types of companies, while other reasons tend to be more inherent to companies such as exporters and domestic manufacturers. It is important for a company to identify and understand the amount of growth it can sustain in an ever-changing economic, consumer and competitive landscape. Once a company understands the level of growth it can sustain on its own, it is better able to identify the amount of incremental business it can handle, and work to find solutions to bridge the gap.
Raising more equity is one way to handle additional growth, but it can be very expensive and more restrictive to existing ownership in the long run. An alternative form of financing such as purchase order (PO) funding is a solution geared specifically to incremental sales. It is a replacement for giving up equity to sustain growth and can provide the time-sensitive results many cash-starved companies seek.
Survival for a business is often determined by the amount of equity in the business — if it grows too fast, there might not be enough equity to sustain growth. According to theory, a company’s sustainable growth rate is based on the earnings that can be achieved from the current equity and the percentage of those earnings that are reinvested back in the business. This is all well and good if a company is sophisticated enough to accurately project earnings, but that is not always possible for companies that don’t have a clear picture of what sales will be over the short term, or for companies that are highly seasonal. Many companies have never experienced significant growth and simply don’t know how to handle and navigate through it. These companies have always had access to capital or supplier credit that has helped sustained sales.
Companies that experience gradual growth in sales are able to sustain growth successfully by accurately forecasting just-in-time inventory purchases that closely align with the cash inflow the inventory was intended to generate. Companies with predictable sales growth are more effectively able to finance those sales through internal cash-flow, supplier credit and traditional lines of credit.
Effective sales financing is not always possible for companies that are seasonal in nature, or with those experiencing sales outpacing sustainable, internally-generated working capital, supplier credit and/or traditional line of credit. These companies find that their cash balances quickly disappear, while their accounts payable, inventory and debt levels sharply increase before they are able to realize positive cash inflow from sales. Long repayment terms given to end customers to further promote growth in sales can add yet another burden on the company’s cash-flow. To make matters worse, exceedingly high levels of debt can exacerbate this cash crunch since creditors can foreclose on assets and force the company into bankruptcy. So begins the vicious cycle of unsustainable growth.
To better illustrate, let’s first examine a company with highly seasonal sales. Several issues arise — companies must schedule production to accommodate for deliveries made within a short time frame. Production lead times must be taken into account, and inventory must be built up and stored in order to accommodate customer shipping windows. This creates a classic instance of mismatched cash flow, since production, logistics and storage costs need to be paid well before goods can be shipped and invoiced. Relationships with suppliers can become strained since companies will always look to lean on trade debt as much as possible to finance growth and suffer higher shipping and logistics costs since they find themselves shipping goods during busy times of the year.
Seasonality also creates issues with asset-based lenders because borrowers tend to experience losses and cash-flow constraints before the shipping season begins, causing a strain on the borrowing base availability that may create unplanned overadvances or a request for overadvances that may not be supported by an asset-based lender.
These types of situations are well-suited for a highly experienced standalone purchase order financier (not a factor that may be dabbling in purchase order finance) who can monitor specific seasonal transactional funding requests for pre-sold inventory, which ultimately leads to the creation of a more liquid form of accounts receivable collateral at the end of the production-to-sales cycle.
Companies growing at a rate that outpaces what internally generated working capital, supplier credit or traditional debt can sustain encounter a constant strain on cash-flow that has a hard time catching up with sales. All of the problems that a seasonal business encounters are magnified with companies that are constantly growing at a rate that exceeds sustainability. Companies in this situation may constantly lean on supplier credit, which can strain those relationships — supplier credit eventually dries up and can reverse itself to the point where companies will effectively be on a COD basis with suppliers just to get more goods released and shipped. Other costs, such as freight and logistics, will continue to increase and will eventually affect deliveries if payments aren’t made on time. Companies will find their free cash flow tied up in pre-production and in-transit goods. They will not be able to cover fixed monthly expenses such as rent, utilities, payroll and debt service.
Even though sales are growing, the company will eventually starve for cash and begin to miss deliveries. If the company has borrowed money to help sustain growth, those creditors will eventually demand to be repaid, or at least keep debt service current. If the company has its free cash flow tied up in production and/or in transit inventory that won’t turn into positive cash flow for some time, secured creditors will eventually foreclose on the loan. Unless a company is capitalized to handle incremental growth, it will eventually go out of business.
Sustainable growth can be more of a challenge for manufacturers and exporters. Manufacturers are burdened with heavy fixed expenses, such as rent, equipment leases and improvements, and labor. If there aren’t enough sales to cover those fixed expenses, the company can find itself burning through equity reserves very quickly. If sales ramp up after a downturn, a manufacturer may not be able to cover direct costs to fulfill deliveries if all of the company’s free cash flow was used to cover fixed expenses during the slow period. Even without a slowdown, fixed expenses make it that much more difficult for manufacturers to handle incremental or seasonal sales. In addition to fixed expenses, manufacturers must have a very good handle on capacity throughout and yield rates of the manufacturing process. These matrices are very important when it comes to profitability and can have a direct impact on cash flow. Production downtime due to supplier issues and/or equipment maintenance can also directly impact deliveries and resulting cash flow.
Exporters also experience unique challenges when faced with sustaining growth in sales. We live in a world that is highly connected through technology, political agendas and social media. Doing business overseas is becoming more common, while prepayments and letters of credit are becoming less common, forcing exporters to extend favorable payment terms to overseas customers to win business. In order for exporters to grow, they must be able to diligently access credit risk and extend payment terms to garner additional sales. Therefore, payment risk has considerably increased. It is critical for a company to be working with a lender experienced in international trade who can mitigate risk of non-payment from foreign customers of a borrower. Purchase order, supply chain and trade finance companies are excellent supplemental financing sources that can work in tandem with asset-based lenders that focus solely on domestic financing. Transit time and added costs associated with shipping goods to overseas customers also has a direct impact on a company’s cash flow and ability to sustain growth. While credit insurance and government-backed working capital programs have helped, many exporters still can’t access sufficient capital to sustain measurable growth.
PO funding is an excellent tool to help finance both incremental and seasonal growth. PO funding is used to finance direct costs associated with specific end customer purchase orders and can bridge the cash flow gap that exists between production and invoicing. PO funding is highly structured and is used to pay for cost of goods directly to suppliers. Additionally, PO funding can cover direct labor, and freight and logistics costs specific to end-customer purchase orders.
Since PO funding is transactional and specific to end-customer purchase orders, a company is able to access additional capital to sustain incremental growth or seasonal sales, even when its balance sheet won’t support additional borrowings from a traditional lender. As a result, companies can use PO funding in conjunction with existing lenders, thereby expanding the capacity to accommodate for spikes in sales. PO funding is the shot in the arm that many companies are desperately seeking to grow aggressively and avoid the growth predicament.
Bryan Ballowe is vice president and chief operating officer of King Trade Capital.