UK: Turn down that order.

UK: Turn down that order. - Question: how can a business with a full order book go bust? Answer: when it is over-trading. Robert Outram looks at ways to grow while minimising the risk.

Last Updated: 31 Aug 2010

Question: how can a business with a full order book go bust? Answer: when it is over-trading. Robert Outram looks at ways to grow while minimising the risk.

You have worked so hard to grow your business and now the biggest order you have ever had comes in. The order promises to hike your turnover by 30%. That has to be good news - so why is your accountant looking worried?

It may be because rapid growth, without the working capital to underpin it, can be anything but a godsend. Profit margins can be hit and the company's cash can disappear into a black hole. In the extreme, the business could go under.

Steve Hill, a corporate recovery partner with audit firm Coopers & Lybrand, has seen more than his fair share of corporate casualties: 'I have lost count of the number of times I've heard a company director saying, "How can my business go bust when I've got a full order book?"'

Over-trading, where a business incurs short-term costs it cannot meet while in pursuit of growth, is a classic problem which is almost always one of working capital. A survey of the chief concerns of SMEs, commissioned by International Factors, found that cash-flow was number one by a long way. Concern about markets and demand came far down the list.

Growth can really eat up working capital. Take the above example: if turnover goes up by 30%, so will direct costs such as raw materials, labour, subcontractors and power. For the typical business, many of these costs will have to be paid some time before any return can be expected from the customer. A big order at a 10% profit margin will typically mean increasing borrowings by 90% of the value of the order until the customer pays. If the orders keep coming, the borrowings keep rising.

Overheads can also go up. For example, extra premises might be needed and more administrative staff may have to be hired. All of this puts pressure on margins. As Terry Smith, a broker with City firm Collins Stewart argues when capital assets, stock and debtors are rising rapidly but cash-flow is weakening, it is time to hesitate: sales are vanity, profits are sanity.

Smith cites both natural cosmetics chain the Body Shop and frozen food retailer Iceland as examples where phenomenal growth was soon followed by an equally steep fall in profit margins. On some counts, both businesses continued to perform as stars, but impressive sales figures could not compensate for slackening profits, with the race for growth giving way to a policy of consolidation.

Large, listed companies are, of course, far less likely to collapse simply through over-trading. They have access to the finance which smaller companies don't and management systems in place to spot the problem in time. But even among the big boys, rapid growth can exacerbate any related problems.

One example is Sterling Publishing, best known as the publisher of Debrett's Peerage. Sterling's core reference books business found a ready market in eastern Europe in the early '90s: turnover for the region went up by 65% to £32.3 million. Much of the revenue came from the advertising the reference books carried, which was generally not paid for until publication.

The problem was that many advertisers did not pay at all or waited for anything up to 18 months after publication. Between 1993/94 and 1994/95 the group turned a £7-million profit into a loss of £8.4 million. Of course, the firm had made bad-debt provisions, but as ever had erred on the side of optimism. Over hasty growth into an untested market meant that what could have a been a local difficulty drove Sterling's share price to a low of 20p.

Niche retailer Sock Shop provides another sobering example. An enormously successful share issue in 1987 was followed by rapid expansion throughout the UK and into the US. Sock Shop, which ran its own stores rather than franchising them, splashed out heavily on new outlets in markets which turned out to be wrong for the company's idiosyncratic approach. The share price slumped and in 1990 Sock Shop went into voluntary administration.

While the problems at Sock Shop probably owed more to misjudging markets than to over-trading, there are two important lessons. First, the chain's founders, Sophie Mirman and her husband Richard Ross, were risk-taking entrepreneurs and their can-do attitude led to some over-optimistic forecasts.

Second, Mirman and Ross had conceded as little equity as possible to outside investors so their expansion plans were funded to a significant extent by bank loans which became expensive when interest rates shot up in the late '80s. So be worried: an inappropriate mix of funding can be the final nail in the coffin of a heavily over-trading company.

Of course, some types of business are more vulnerable than others to the problems over-trading can bring. It is endemic in the construction industry where staff, raw materials and subcontractors all have to be paid for even if the prime contractor is out of pocket. Printers are also at risk, operating as they do in a highly price-sensitive market and depending on a relatively small number of powerful suppliers. By contrast, cash businesses such as supermarkets and restaurants can often find growth actually adds to their working capital, since they should normally be getting a cash return before their payments to suppliers fall due.

Guy Stead, marketing manager at Maddox Factoring, cites the example of a temporary staffing agency which took advantage of a buoyant market to expand rapidly. It had no trouble finding a fast-growing pool of temps or even of customers to take them on. The problem was that, while temporary staff will not stay with an agency if they do not get a wage every week, customers will typically not pay up for three or four weeks. With that kind of lag, the rapid growth created a working capital gap which needed extra funding. In this case the extra cash came from a factor.

Cash-flow is, of course, the key indicator that the business is at risk of over-trading. For a smaller company, continually running up against overdraft limits can mark a problem that simply upping that limit won't be able to solve. Other key pointers include the quick ratio or acid test: the proportion of cash plus debtors to current liabilities. An increase in the age of work in progress also indicates trouble ahead, as can a disproportionate increase in stock.

Timely management of information is vital for corrective action. For a larger company, this should be a matter of course. The problem for many smaller companies, says Brendan Guilfoyle, president of the Society of Practitioners of Insolvency, is that they rely on lagging indicators like profit margins. They think they know what their margins are, but find out far too late that these have been seriously eroded.

Of course, small businesses, blue-chip plcs and government departments all share one key tactic for maximising working capital: pay your bills as late as possible and collect cash from your creditors as quickly as you can. Credit control is obviously vital, and keeping track of debtor days - the average time to collect payment once billed - is important to ensure that it does not run out of control. As a rough guide, the figure for UK Ltd, according to KPMG's aggregated analysis of owner-managed business, is currently 42 debtor days. That figure incorporates very different industries, however. In the food sector, terms are typically seven days while 30 is standard for most of industry.

The funding gap appears when the terms for debtors and creditors are out of sync. So as well as looking at credit control, companies must ensure that the type and timescale of funding is appropriate for the needs of the business. The classic error is to fund working capital, fixed assets and everything else through one bank overdraft. Not only can this prove expensive, it also leaves the bank with the terminal option for the firm, that of reducing the facility if the bank is getting nervous or, worse still, of foreclosing the debt if covenants are breached.

Frustratingly for the small growing business, overdrafts tend to be limited by the company's assets as security for the loan, or by the overall worth of the business as shown in the previous year's accounts - even though it may already have grown significantly since then. This tension between business and banking is neatly summed up by Ben Allen, chairman of Kellock, the Royal Bank of Scotland's factoring arm. As he puts it: 'The term over-trading is used by banks when people want more money than they are prepared to lend to them.'

There are signs, however, that the overdraft is being replaced. The Bank of England's report on funding for the smaller business showed that fixed-term loans now account for nearly two-thirds of bank borrowing in the sector. Banks themselves now only supply 52% of external finance for smaller businesses, and asset-based financing, such as leasing, hire-purchase or factoring, is growing rapidly.

Relations between banks and their customers hit a low during the last recession and since then, banks have started to offer a more varied package of funding options. NatWest, for example, offers medium-sized businesses a fixed-rate loan package for up to 25 years, or a mix of bank lending and asset-based finance.

This didn't come soon enough for some. Graham Ducker, managing director of the Hertfordshire-based Smokehouse Station, turned to factoring, which he describes as a healthier alternative to bank lending, to launch a new product into the UK marketplace. Pit barbecues are a popular product in the US but unknown in Britain - just the sort of uncertainty banks are uncomfortable with. So Ducker funded his imported stock through Maddox Factoring. The deal provided the working capital necessary to cover the gap between the 30 days demanded by his US suppliers and the 45 days typically taken by dealers in the UK to pay. It also allowed sales to grow rapidly from a start-up in October last year.

But factoring, where funds are advanced against the company's trade debtors, can be a comparatively expensive way to raise money. Nonetheless, factoring and invoice discounting - with the latter, customers are not aware that their debts have been traded - are increasingly becoming an accepted route to fund growth. And now that most of the big names in factoring have been acquired by banks, clients are more likely to be offered a combination of factoring and traditional bank lending. The cost has two elements: the cost of the money advanced, typically between 1.5% and 3% over bank base rates and a service or management charge to reflect the cost of collecting the debts.

Just how much working capital each percentage point of growth will need depends on the nature of the business and the terms on which it deals with suppliers, staff and customers. Ultimately it comes down to an understanding of the cash-flow: managers must be able to predict and monitor their cash requirements. Without that information, the dash for growth can put the company's profitability - even survival - at risk.

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