Just a few years ago Jack and Seth were on top of the world. Both in their late 40s, their nascent business was really hitting its stride. An importer of high-end designer tiles installed mainly in high-end homes, revenue had been growing rapidly, hitting $3,200,000 in 2004. Each of them drew a $150,000 salary and another $400,000 fell to the bottom line that year. They bought a new 20,000-square-foot warehouse and each a new house and truck.
Today, the company no longer exists. It filed for bankruptcy and was liquidated this spring. What went wrong? Take a look at summary financial information for the company in 2004 and the most recently completed full year, 2007.
Here’s what happened. Perhaps we all can learn from their mistakes.
- A single customer accounted for 60% of their revenue in 2004, well over 30% in the flanking years, too. Jack and Seth knew this customer concentration was a big risk, but they ignored it. They were just so enamored of their newfound prosperity that they failed to acknowledge that the foundation was weak. The customer bought nothing from Jack and Seth in 2007.
- The large customer was a sizeable flooring retail chain. The big purchases in ’04 were largely the initial stock-up of Jack and Seth’s product. Once the customer’s inventories were stocked, sell-through (i.e., buying from end-users) was required to pull additional tile through the chain. Unfortunately, and despite Jack and Seth’s optimism, the line performed poorly and eventually was discontinued. The customer had cautioned Jack and Seth that the original volume purchases were to fill the retail shelves and that sell-through was needed to make this partnership a success. Tragically, they ignored this sobering reality.
- Terms of the sales to the large retail customer allowed unsold product to be returned. So, in effect, a sale was not really a sale until it actually was sold to an end-user. Again, Jack and Seth ignored this reality, booked the revenue and profit in their accounting system and ignored that the goods might end up back in their own warehouse. In fact, this is what happened.
- Given that Jack and Seth were buying inventory from a Chinese manufacturer and selling most of it to a retailer that had almost unlimited rights to return it, Jack and Seth should have negotiated the right to return unsold inventory to their supplier. But Jack and Seth were so excited to get the supply contract that they gave in on this demand. It cost them their business.
- Despite all of this uncertainly, Jack and Seth went on a buying spree and, even worse, took on debt to finance it. They added staff, purchased a nice new warehouse, and bought fancy new trucks, forklifts, computers, software, inventory management system and furniture. They both bought expensive new homes. As a result, expenses and fixed obligations rose drastically.
What could they have done differently?
Certainly, the first big risk that they took was agreeing to buy large amounts of inventory with no right to return. Securing this deal term would have helped a lot. They probably should have held out or found another supplier. Often, you secure your victory before the game is ever played. That is when the rules (terms) are established between the parties.
Second, they should have had the maturity and humility to accept that their success was on very shaky ground. Sure, they were having some success, but it’s the long run we need to work to win, not the short one. Given that their sales were pumped up by a single large customer that was “stocking up” but had a right to return the purchased goods, Jack and Seth should have remained very cautions. They should have worked hard to minimize the inventory they carried, kept expenses low and avoided fixed obligations both personally and within the company.
If they would have done these things, their business could still be in business today. Sure, they could have done other things: maybe being tougher on return rights granted to their large customer, maybe refusing to personally guarantee the bank debt. But both of these would have been difficult to obtain and neither gets at the root of the problem. The fatal flaw was failing to address reality. To succeed in life and in business, we have to be optimistic advocates of our own interests and prudent protectors against things that could take us down fast.
| 2004 | 2007 | ||
| Sales | $3,200,000 | $700,00 | |
| Pretax Profit | $400,000 | ($900,000) | |
| Book Value | Book Value | Liquidation Value | |
| Cash | $10,000 | ($75,000) | ($75,000) |
| Receivables | $950,000 | $700,000 | $500,000 |
| Inventory | $650,000 | $900,000 | $125,000 |
| Land and Building, Net | $0 | $650,000 | $650,000 |
| Total Assets | $1,610,000 | $2,175,000 | $1,200,000 |
| Trade Payables | $350,000 | $800,000 | $800,000 |
| Accruals | $50,000 | $100,000 | $100,000 |
| Interest-Bearing Debt | $100,000 | $700,000 | $700,000 |
| Capital Leases | $0 | $50,000 | $50,000 |
| Total Liabilities | $500,000 | $1,650,000 | $1,650,000 |
| Equity | $1,110,000 | $525,000 | ($450,000) |
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2012.
This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.
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