Australia: Miscalculating profit margin results in desperate measures to source funds

Revenue is vanity, profit is sanity, but cash is king.

Time and time again as insolvency practitioners we see businesses experience cash flow issues for various reasons and seek funding to meet their trading obligations, usually with little regard to if the short-term funding measures will be viable in the long term.

Statistics from the Australian Small Business and Family Enterprise Ombudsman and Xero's Small Business Insights Report reveal that only 50 percent of small businesses were cash flow positive in January 2019 with a significant amount of cash tied up in accounts receivable. We agree with this finding as we often come across situations where supplier trade accounts well and truly exceed the agreed limit. Commonly suppliers look at the sales figure rather than keeping a close eye on the credit that is steadily increasing in size, which leaves cash tied up and them vulnerable should the creditor fail to pay. Sometimes sales targets exacerbate the issue, by rewarding more sales at the expense of tying up funds in accounts receivable. Feedback from these creditors regularly reveals that there is a lack of communication between the sales team and the accounts department.

The following is an example of a liquidation we handled where the opposite was true, as sales were being paid up front but was still constantly short on cash. To continue trading, the directors went to extreme lengths to obtain funds.

The company operated a small manufacturing business in Brisbane. Our review revealed that the director (a tradesperson by trade) conducted his cost analysis of manufacturing each item the company made and set the sales price to make a profit. It appears however, that he miscalculated and omitted company overhead expenses from the equation and therefore losing money on each sale.

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To setup the company initially, the directors invested their personal funds to setup the business. Approximately two years later the company needed to source funding for its operations and the following ensued.

Outside the usual channels of sourcing funding, the company ran three "crowd funding" campaigns, which looked to customers for that critical source of funds. In total, the company obtained funds of almost $1million though this method from customers in Australia and the USA.

Those funds were quickly spent on operating expenses and due to the consistent lack of cash the company continued to collect more deposits from new customers (totalling a further $700,000). Because of the attractive pricing the orders kept on coming. The directors then enabled 'queue jumping' by requesting extra payments from customers "to get their order earlier" while selling newly manufactured units for cash to new customers instead of the existing customers­—who had already paid and were still waiting for their goods.

The directors then stopped paying superannuation contributions 'saving' the company approximately $150,000, which it could then use for trading expenses. Lodging BAS was next on the stop list and again, to assist in funding trading expenses, used the funds instead of paying its PAYG and GST obligations.

On top of these 'measures', the directors opened a $200,000 company overdraft account and a $10,000 credit card, which was secured against the company and the director's personal home. The directors then attempted to source funds from investors. Through a family contact they found a private investor based in the USA who after visiting the manufacturing facility provided $2million over a period of 10 months, unsecured, to the company.

In addition, one of the directors then used a personal credit card up to its limit of $70,000 to purchase materials and pay company creditors. Lastly, they opened an invoice funding facility with a second-tier lender and directed a related entity to the company to issue invoices for services rendered. It obtained over $100,000 from this facility.

In all cases all revenue generated, and funds advanced through the above sources were swiftly spent to meet its ongoing trading expenses. The directors likely thought they were doing the right thing by doing everything they could to keep the business going, always confident the company would soon turn a profit.

Eventually all these practices caught up with the company to the point where the debts had reached critical mass and it had insufficient money to pay wages to its 27 staff. Putting aside the unconventional and intricate cash-flow 'systems', which even the most seasoned accounts departments would have been bewildered by, the systemic problem was pricing. Had the directors obtained assistance from a management accountant to correctly calculate the profit margin, with allowances for both direct and indirect costs, while keeping a close eye on management reports and cash flow: its fate may have been avoided.

As a wise person once said (origin unknown), "Revenue is vanity, profit is sanity, but cash is king."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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