From March through May of 2020 businesses nationwide faced the first peril of failure, a significant drop in sales. In many cases this drop moved the firms beneath their break even points. With the economy reopening, these same companies will face the second peril of failure, rapid growth. Being weakened by the drop in sales many will struggle to fund the growth ahead of them. Bankers as well as owners need to plan now, determine the resources their clients have, assess the sustainable growth level they can maintain as well as produce a plan to avoid growth liquidity trouble.
The first on the list is to determine what resources a firm has to survive on. What is the level of funding that could be drawn from the existing accounts receivable? Is there inventory that could be sold quickly? Are there ways to extend the accounts payable without upsetting suppliers? Now is the time to develop a cash budget of all the sources and uses of cash on a weekly basis, looking out as far as feasible.
Calculating the sustainable growth level is the next step. The level of sustainable growth for any firm is a function of five variables; The after tax profit margin, the target dividend payout ratio, the current leverage of the company, total assets to sales and payables to sales. Essentially these are the key sources and uses of funds that will inhibit or allow growth to occur. Based on the interaction of these variables the level of growth is ascertained which can be maintained without a liquidity issue occurring. If a firm exceeds the sustainable growth figure, one or more of the five variables will have to change, producing more cash for the firm. Without that cash the firm will not be able to increase the balance sheet to meet the sales growth thus leading to a liquidity crisis for the firm.
Once the level of sustainable growth is known, a plan for actual growth can be made. Management can monitor the sales on a daily or weekly basis to determine trends. They may also wish to segment sales by gross profit margin to cull the herd as they say. If sales levels are expected to exceed the sustainable level, management could focus on the higher margin sales and pass on the lower margin sales. Otherwise, the banker and the owner should orchestrate how best to fund the growth. Options include curtailment of the dividends, added bank financing if the firm qualifies, or a combination of a number of variables including extending the payables.
With the first peril of failure passing, do not let your clients succumb to the second failure of growing too fast. With resources now limited, figuring out the sustainable growth level for your client will be critical to their survival. If you need assistance in working with your clients on sustainable growth contact us at Stevens Risk Management, LLC. We can consult with you and your client to put a plan in place.
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