Cashflow and survival

This is a story about cash. Cash is the life blood of a business. Now, I know that everyone will say “so what, everyone knows that”.

Unfortunately, while they might know it, many people ignore the fact, and managers so often get carried away with non-cash numbers so much so, that like Albert “Chainsaw” Dunlap when CEO of Sunbeam Appliances, they do silly things to get these non-cash numbers on their books, little realising that they are thus threatening their survival.

But let’s take the example of Sunbeam.

In 1996, the venerable company that had established its reputation and brand by producing home appliances for just about every home in America was in trouble. It was consistently failing to meet its numbers and was being given the thumbs down by Wall St with the result that its share price was in a trough and investors were unhappy.

There were serious doubts about its continued existence. So, the decision was made to get in the whiz kid of turnarounds, Chainsaw, to be the CEO.

Within a short time of his arrival at Sunbeam, Dunlap had embarked upon an upheaval of massive proportions by closing factories, even though they were producing products for unsatisfied orders; sacking half the staff and issuing stock options to his top executives that they could cash in if they made numbers.

In all of the stuff that is printed about his involvement at Sunbeam, it is difficult to come across mention of product relevance and quality or response to customer feedback. Dunlap was a numbers man. People on Wall St are numbers people. Wall St loves good numbers and unmercifully punishes bad numbers. Companies that don’t make their numbers get a caning.

Now Sunbeam made house appliances such as electric blankets and electric grillers and they sold them to big players such as Wal-Mart. People tend not to use electric blankets in the northern summer with the result that they tend to buy them in the winter months from October through to March. However, in the third quarter of 1997 there was a massive increase in the number of sales of electric blankets.

The market hailed this as another of Dunlap’s miracles. He was able to increase sales out of season. No wonder he was hailed as the turnaround hero. Then in the next quarter when winter had set in and people went indoors, sales of grillers often used outdoors for barbecues went through the roof. This guy was a genius.

The profitability of Sunbeam was exceeding Wall St expectations and the share price was responding accordingly. Everyone thought that they had the right man in Dunlap (except a lot of people who worked in the company).

Then suddenly the miracle stopped, and Sunbeam had to announce a downgrade in profit. They put a spin on it by talking about new products and so on, but the fact remains that Dunlap was faced with the situation where he had not delivered on his announced profit goals.

What someone did (and the fact that most analysts didn’t indicates the extent to which you can rely on stock analysts) was to look at what is called the “balance sheet” of the company. The balance sheet indicated that the amount of money owing to the company by customers had increased enormously in the quarter when sales of electric blankets and grillers had gone through the roof.

Drilling down, it was found that Sunbeam had done a deal with many of its suppliers whereby Sunbeam would “sell” stock today at a discount that the distributor would not want for many months and hold the stock in an offsite facility until needed by the distributor. The distributor was only liable to pay the discounted price upon receipt of the stock. What a deal!

In short, Sunbeam was manufacturing stuff that it was not going to deliver for many months and then pretending to “sell” it. It then registered the “sale” as income and disclosed this in its accounts as income even though it had never received the cash.

The profit was fictitious and no one, with the exception of a few analysts, picked up what was happening. Analysts recommended the stock and the share price went from about $8 to nearly $50 in no time.

Sadly, for Dunlap, winter came around as did summer and all of the stores had long stocked up on Sunbeam appliances months earlier at discounted prices. So, what happened to the next set of figures?

With a bit of accounting dexterity approved by the auditors, Arthur Anderson, the figures were bad but not disastrous. However, people started to look more closely at the accounts and then of course, the proverbial hit the fan.

The sales and the profit were fictitious accounting tricks and when that trick had been played, there were no more tricks in the cupboard with the result that the share price tanked and the company was in fact facing bankruptcy.

On the right is a graph of the share price of Sunbeam when Dunlap was in the chair.

Years ago, I was called into a very successful law firm. In fact, I consulted to quite a few that all had the same problem. “Everything is fine, we have plenty of business and are working flat out, but we have a cashflow problem.”

I shudder whenever I hear that term “cashflow problem” as though it is a wonderful way of saying you haven’t got a problem when you have.

Anyway, these law firms disclosed healthy profits year on year upon which they were invoiced by the taxation department for income tax. The “cashflow” problem was so bad that they had to ask the tax collector to wait a while until they got over their problem at which stage they would pay the tax.

The problem was simple. There was nothing sinister in it, as was the case at Sunbeam, but the problem was identical.

The law firm billed on an hourly basis and at the end of each month each lawyer had to achieve a certain number of “billable” hours. The bills would go to the various clients and then be clocked up as “income” in the computer.

The client would get the bill and say “hell, I can’t pay this until my case is settled and I didn’t know it was going to cost so much”. So, the client doesn’t pay the bill and when he or she gets a call from their lawyer who wants some information to progress the case, they don’t answer the call for fear of the cost going up and getting another bill at the end of the month.

The file stalls and the amount billed on that file goes into what we call “debtors”. Until that bill is paid, it is not cash but a fictitious amount in the books of accounts.

All of the so called “profit” of the firm, which was attracting income tax (which wasn’t getting paid) was simply a book figure, just as the income at Sunbeam in relation to the sale of electric blankets that had never been delivered was a book figure.

What was worse, Sunbeam and the lawyers had been able to borrow a stack of money based on their “profitability” and also one of their assets, which is roughly called in a balance sheet of a company “debtors”.

If people owe money to a company, that debt is considered an “asset” because it is looked upon as money that will come to the company in the ordinary course of events. However, that asset is not as secure as bricks and mortar because there is no guarantee that people will pay the debt nor when it will be paid.

In the case of the lawyers, people owed the lawyers hundreds of thousands of dollars and had done so for a year or more. When people owe money for that length of time we tend to call the debt “bad”. Rather than being an asset, it is a liability. When you borrow money against an asset which is deteriorating, the amount of money available to pay back the amount borrowed is also deteriorating.

Sunbeam and the lawyers and many businesses greater and smaller and many in between get caught with this same problem of “cashflow” because they fail to understand that income is not really income until it is cash in the bank.

Survival depends on cash and locking cash in during the good times ensures survival when times aren’t so good.

The trouble is that some people only discover this when the economy has turned and the banks are chasing them.

There can be many reasons for poor cashflow, but from a survival point of view there are three main reasons, and they are not exclusive of one another.

1. Poor or lax financial management.
2. Personal creaming of the company’s cash.
3. Poor product and customer satisfaction.

It doesn’t matter how good times are, when cash goes out the door it is gone. Sound financial management will ask, before signing the cheque “what are we going to get for our money?” Apart from the distribution of income by way of dividends, money paid out by a business should be looked upon as an investment.

Money paid in salaries, money paid for equipment, money paid to occupy premises is money lost to the company unless it gets something in return. Cash is precious, and before parting with it management should be completely aware of why it is being paid.

Management often doesn’t turn its mind to the fact that in order to ensure that owners or investors get a return on their investment, the company has to get a return on any money it spends.

If a company gives credit, such as was given by Sunbeam and the lawyers (how many companies today are offering “no payment for 12 months”?) it has to ask itself “what am I getting for this credit that I am extending? After all, banks are intended to provide credit; providing credit is not our business.”

Providing credit is like writing out a cheque. You have to ask yourself, why am I writing out this cheque? If it is to enable people to take some stock off my hand without paying for it, will I get the money back and if so when?

On the other hand, management sometimes takes this too far and becomes what are commonly called “bean counters”. They are the people like Dunlap who don’t think about product, customer service or ensuring there are sufficient resources in the business to make it work. “We need to get rid of so many people” which means that a specified number get the pink slip. Next day, a customer walks into the shop and there is no one to serve them and so they walk out again.

This means that decisions not to spend have to be scrutinised as seriously as decisions to spend. “By retaining this money will the return on investment be greater than if I spend the money?” Bean counters are often unable to make that call. Sunbeam cut its IT department with the result that staff had to revert to manual invoicing. The results were chaotic and caused serious customer defection.

In good times, there is a tendency to take the eye off the outgoing cash in the belief that there is plenty more from where it came. Cash is the same in good times as in bad and the question always should be “is spending this money a wise investment or, if I don’t spend the money, will that be a good or bad investment”.

Too often, financial decisions are made without consideration of the essential transaction in which a business participates, which is the delivery of a benefit to a customer for a price. As a result, product integrity often takes second place to financial reporting; ultimately, as we discovered with Sunbeam and a host of other bankrupt companies, with catastrophic results.

If a business has neglected its financial management in good times and is looking at a terrible hole when things have turned bad, it is unlikely that banks will lend a hand. Rather, they will want to get paid before something terrible happens. Most companies can’t go to the government for a bail out, and things look pretty desperate. This is the time when a decision has to be made to surrender so that you can fight another day or to dig deep and hold on.

That is when you go back to the graphs. It is something that Dunlap should have done when he first walked into Sunbeam. Do the graphs indicate that your product is the ants pants, or are you just one of many who, with a bit of luck and the wind behind the economy have been lucky to make some money? Is there something really, really special about your product that people love.

Have you built a brand so that people will say, if you want to buy a fixit, “you have to go to so and so”? If you have something special and people love it and will keep buying it, albeit in smaller numbers, that is the time to sit down with your banks, accountants and customers (who are often investors themselves) and come up with a plan to survive and come out the other end with a decent business.

However, if you have been deceiving yourself and running the business as though it were an accounting machine with no relation to product integrity and the benefits conferred on your customer, then perhaps the best thing is to cut your losses and hope to start again with a business that does confer enduring benefits on customers.

Finally, if owners and managers have creamed the company, as in the case of the big banks, then the time is to put it back into the company after developing a survival plan. If, on the other hand, the money has gone to the airlines, travel agents, Mercedes Benz dealers and the like, then it is going to be tough to make a comeback.

Wherever you are in the business cycle, you have to envisage the necessity to survive, and no accounting tricks will secure sustainable survival. Only customers will do that, and if they desert you in droves in a downturn and you haven’t kept some money in the tin in the good times, survival will be difficult.

Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.