Does your company’s profitability and growth hide a multitude of sins?

By Richard Tyson

My client was basking in the glow of strong profitability and amazing demand for his products. His company, a manufacturer and online retailer of high-end attire for pre-teen girls, had reached the “tipping point” that author Malcolm Gladwell identified in his book by the same title.

He had reason to believe that his ship had come in. As we walked his plant floor, he shared his formula for success: exceptionally creative dress designs that had caught the eye of influential New York couture leaders, rapid prototype production, reliable international sources of fabric and other components, a lean manufacturing process and highly effective Internet marketing and sales. How could he possibly lose?

I had to agree. He had created something quite remarkable. However, one of my jobs as a business coach is to have an observant eye and to ask questions about what I see. In that regard, I noticed huge racks filled with an incredible array of fabric. I asked if this raw inventory had found a temporary home on the racks enroute to becoming new dresses.

My client’s reply surprised me. He said, “No, this inventory is remnants of designs that we didn’t produce. We used some of it in our prototypes, but it is now scrap.”

I then asked if he knew how much money was tied up in this scrap inventory. He said that he didn’t, but that he was unconcerned about it. And then he said the words that I hear far too often — words that chill my heart: “We are doing far too well to worry about distractions like that.”

I suggested that he look for potential buyers for the scrap, even if he only could get pennies on the dollar for it. But he dismissed the idea; “We’re too busy chasing real profit dollars to waste our time on that,” he said.

Not even a year later, my client’s company was in deep financial trouble. Somehow, in spite of showing profitability on their income statement, they were out of cash. How could this have happened?

Quite simply, my client failed to understand his company’s cash conversion cycle. This is the amount of time that his money is tied up in inventory (raw goods, work in process and finished goods), plus the amount of time it takes him to collect accounts receivable, less the time he takes to pay his accounts payable.

Although my client was blessed to collect his receivables rapidly (since virtually all his revenue came through credit card purchases), his cash conversion cycle was, nonetheless, inherently long. The business required significant inventories of fabric. This was exacerbated by the fact that he was competing in the fashion industry. Even though he had initially been successful in impressing the fashion world, their accolades were fleeting; he had to continually make strong impressions. And when some of his designs and prototypes failed to appeal, a growing pile of scrap fabric accumulated. This was worsened by a failure to purchase small quantities, at least during the initial prototyping stage.

My client simply failed to see his burgeoning inventory as enormous stacks of dollars, clogging up on his shelves.

When we finally sat down and analyzed his situation, he had “grown broke.” In order to sustain his booming market, he failed to manage the critical elements of his cash flow. His working capital needs and operating overhead continued to grow while his cash conversion cycle expanded as well. In the end, he determined that his only option was to close his doors.

My client’s myopia on his early success preceded a colossal failure. It is a cautionary tale of which I take no pride. I simply couldn’t get his attention on the fact that his strategy, for all its strong points, had some fatal flaws.

My message here today is certainly not to suggest that we shouldn’t enjoy the successes of the moment, but, as we do so, to always ask ourselves “what are we missing?” In this regard, we must continually seek the proper balance between generating cash and consuming it.

Too often, small-business leaders fail to recognize that even a profitable business that grows too fast may run out of cash. In the end, this may be the most prevalent reason for business failure.