Impact Partner Content: Absa | By Justin Schmidt, Head of New Sector Development, Absa Retail and Business Bank
“Revenue is vanity, profit is sanity and cash flows are reality”. This phrase may sound like a cliché, but it is a really important consideration when businesses move into their next growth phase. A major contract may look great from a revenue perspective, but if there are mismatches in the working capital cycle (timing differences of cash going out and cash coming in), the growth may not be worth it.
Refilwe Sebothoma, the CEO of PBM Group, walked me through her business journey and the vision for the group. PBM supplies an impressive list of blue-chip customers with a premium range of Personal Protective Equipment (PPE). Refilwe has also made inroads to becoming the “supplier of choice” to her targeted sectors by ensuring PBM has a strong value proposition that focusses on quality products, service and quick turnaround times. While this focus has delivered strong growth for PBM in recent years, Refilwe’s goal is to exceed that growth in the coming years. Refilwe has a realistic view of the future – her conservative stance has held the business in good stead, allowing her to get her systems, staff, suppliers and customer base in place before she takes on overly ambitious growth. Thanks to her groundwork, PBM is now looking to leverage off its base and move to the next level.
A key consideration for Refilwe, and a headwind in terms of growth, is funding her working capital cycle. She recently turned away a very large order from a blue-chip company because “the growth would have been too fast and I did not have a facility in place to take on those cash flow pressures”.
The cash conversion cycle
Managing cash flow is an essential consideration for business success. Let us therefore consider the cash conversion cycle (CCC) of a business and how capital is tied up at each point in this cycle. The CCC is a measure of how long it takes the company to turn its cash investment in inventory back into cash (from sales of that inventory). The longer the CCC, the greater the amount of capital invested in the sales process. The CCC also takes into account how long it takes a business to pay their suppliers (in the form of the payables payment period). If the CCC is greater than 0 days, the capital tied up in this cycle will need to be funded by some form of short-term finance (in the form of cash or a facility like an overdraft).
An important consideration is that these sales need to be converted from receivables back into cash – until the money from a sale is paid into the bank account of the business, this cash is tied up as working capital. Importantly, when cash is locked up in the sales process, it cannot be used anywhere else in the business.
This is an issue that the PBM Group has had to deal with in growing the business. Funding is the next lever required to enable growth. Recently, Refilwe had to say no to a contract with a big corporate because the payment terms they offered were 90 days. Refilwe knew this would put cash flows under pressure and therefore had to walk away from the additional revenue because she didn’t have an overdraft in place to assist with this cash flow mismatch.
Strong relationships with your suppliers
Through delivery and appropriate relationships, suppliers often give companies payment terms that allow them to delay payment for the inventory. However, there is a limit to the credit they can offer (often only reviewed annually and many times dependent on the insurer of that company). Therefore, this is a headache and constraint for business owners like Refilwe who are seeing strong growth in their businesses. There is also often an upfront cash discount for early payment, therefore you can utilise cash to pay upfront or use bank funding to pay upfront, but the costs and benefits would need to be weighed up.
The longer your track record and the more your suppliers see you deliver, the greater the benefit to both parties in the form of increased sales and a mutually beneficial relationship. Refilwe highlighted the need to keep suppliers happy by always delivering, paying on time and growing, therefore becoming an ever more important partner to them. The benefits of this can also end up being better pricing or rebates, which businesses can pass on to customers.
Funding of working capital cycles
Let’s consider how to fund growth and the working capital requirements of a business like PBM by way of an example. The assumptions are:
There is a new order of R36.5m for the year which equates to R100,000 in sales per day
Suppliers offer 30 day terms (i.e. a payables payment period of 30 days)
The product being sold makes a 30% gross profit margin for this order
The company only sits on stock for 15 days (i.e. an inventory processing period of 15 days)
The customer has a 90 day term (i.e. a receivables collection period of 90 days)
Therefore, the cash conversion cycle (average receivable collection period plus inventory processing period minus payables payment period) is 75 days. The average daily credit sales are R100,000. A proxy of the working capital need is CCC times average daily credit sales (more specifically we calculate the value of capital tied up in each component of the CCC) and therefore the overdraft requirement is roughly R7.5m (more accurately it is R7.95m).
In order to take on this new order, the business needs to see if they have R7.95m in cash flow to fund this new customer order or if they can partner with their bank to utilise an overdraft to finance the working capital requirement. This is the dilemma that Refilwe had when she had to walk away from her large order.
Partners in growth
While a safe disposition and conservative mindset have served Refilwe well to date, she now wants to ensure that she does not miss out on these blue-chip customers and can also deliver on more bulk orders as they come around. Given that the focus is on service and quick turnaround times, if at any time she fails to deliver this will mean she loses her customer’s trust. In 2019, she has focussed on hiring more team members and a strong support structure to free up her time to get new business and focus on the future. She also ensured PBM had a customer relationship management system to stay on track and deliver on their promises. Going forward, the other key partner in the journey will be a bank that can offer the correct level of funding to ensure that when that order comes in, Refilwe is able to run the numbers, weigh up the risks, see if this is a customer that she wants to bring onto the books and get closer to her ambitious growth targets.
In 2020, she is looking to grow off her strong base, stick to PBM’s core strengths, get even more blue-chip clients in the her focus sectors and have a funding line in place that allows her to finance these increasing working capital needs.