Barely a day goes by without another headline, TV news story
or current affairs feature on the Resources boom and how WA is the top gear in
a 2-speed economy. But for many small and medium sized suppliers to our
resources behemoths this boom could just as easily blow up in their faces if
they don’t keep a wary eye on some key business fundamentals. Here we highlight
some of the key risk factors we’re seeing emerging in the market and give you
some tips on how to negotiate them.
So what are the particular market conditions which create
this risky environment?
·
Relatively few, large buyers with significant
market power – the large mining, oil & gas companies and operators
·
Rapidly increasing sales
·
Tight labour and materials supply conditions
We all hear about “bottom line focussed” business operators
but astute business managers know that there is a triple bottom line that is
the key to a successful and sustainable business.
The first bottom line
is Net Profit after tax (NPAT). Business only survives if it makes a
profit. The key issues here are: pricing, discounting and cost control.
Effective pricing requires up to the minute market knowledge, current component
cost information, accurate and complete job specifications and scope and a
robust financial model which provides the guidance on minimum margins to be
obtained.
Discounting is anathema to good business management. Every
business should know its “walk away” price below which it is not worth winning
the business – and the walk away price should be one at which the business
makes a sustainable profit. Too often we see businesses discounting in order to
win significant contracts but without a real understanding of the risks they’re
assuming as a consequence.
For example, fabricators to the mining industry should be
pricing to achieve a gross margin of about 28%. A typical business turning over
$15million should be aiming for a NPAT of $1.2 million. But if they were to
discount by, say, 10% in order to win the business then they would actually end
up losing $300,000 even if their sales grew to maintain revenue at $15 million.
In fact, in order to make the same profit they would need to grow their sales
by 55%!
In contrast, if they can achieve a 5% price premium then
they can actually afford to lose 15% of their business and still make the same
profit.
The second bottom
line is Return on Assets. In a rapidly growing business capacity needs to
be expanded and this will inevitably mean not just additional hard assets in
the form of machinery and materials but also soft assets such as work in
progress and debtors. Growth in assets can only be funded in three ways –
additional debt, additional capital or retained profits. In a rapidly growing
market retained profits are unlikely to be reinvested fast enough to support
rapid growth so that reduces the options. And as many businesses in the
resources services sector are private companies then additional capital often
means additional personal debt.
With most businesses you can’t create additional capacity in
a smooth line – putting in a third assembly bay is a 50% increase in capacity
but it might only be servicing a 30% increase in production. This sort of
scenario is going to inevitably result in a reduction in return on assets.
Instead, look for options to make your assets work harder.
Improved production scheduling, additional shifts, more flexible workforces all
improve asset utilisation. And in a market like this where capital is scarce
and lenders hard to get on with you want to make your assets work as hard as
possible.
The third bottom line
is Operating Cash Flow. In a healthy business, operating cash flow should
always be higher than net profit after tax – the excess is what allows you to
fund asset purchases, depreciation, loan repayments and dividends. The huge
risk for a rapidly expanding business is depletion of working capital – the
ability to pay your bills each month.
The sponges that soak up working capital when business is
expanding are work in progress, materials and debtors. Do you know what your
working capital funding requirement is? This is the amount of additional
working capital you need to fund every extra dollar of sales. The key factors
impacting on this are:
·
The level of inventory you keep;
·
The length of time it takes to convert and order
into a delivery; and
·
The length of time it takes to convert an
invoice into cash.
Expanding faster than your fundable growth rate is a fast
track to insolvency. Creditors get stretched and suppliers start to put the
brakes on. The bank sees you at your limit constantly and starts to get
nervous. Superannuation and tax commitments aren’t met on time, begin to
compound and then you have the ATO on your doorstep. It’s a nightmare scenario
and all driven by increasing sales, even profitable ones!
The silver lining
to all this is that all these risk factors also work in reverse. If you know
your pricing and stay in control of your costs you can increase profit without
having to increase turnover beyond your capacity. This will turn your business
into a cash flow generator and you’ll find yourself in the fast lane. It’s all
about knowing what’s going on in your business and remaining in control – or,
if you like, keeping a tight rein on the bucking bull!
© Bruce Fielding, Sarion Advisory Pty Ltd 2012
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