Case Study: The Risk of Sales ConcentrationsPosted on June 10th, 2017
Outsourced Accounting Department, Inc.
In my previous article, “The Good News: Your Business is Growing – And That’s Also the Bad News,” I talked about how rapid sales growth can also create the need for large amounts of working capital to support it. This need was subsequently met via an asset-based credit facility, so the business was all set and off and running – that is, until the unexpected happened: some major customer contracts for various reasons never materialized. And by this time, the company had already incurred large capital lease obligations on the equipment lines necessary to support its projected sales to these customers. In other words, its fixed costs had increased substantially, and therefore, its breakeven point of sales.
Thus, the company found itself in a major turnaround situation to fill its sales and production pipeline as quickly as possible to absorb its fixed costs (equipment leases). Simultaneously, the company had exceeded its borrowing base on its asset-based credit facility, and was instructed by its lender to “stop writing checks immediately.” (And the almost humorous irony was, this company had recently been named by a local magazine as the “fasting growing company” in the region, precisely at a moment when it was on the verge of bankruptcy.)
Major steps were subsequently taken, including downsizing its employee staff while simultaneously negotiating extended credit terms from major suppliers, combined with revising its marketing strategy to target high volume contracts to absorb its fixed costs. Then coincidentally, the company won a lucrative contract from an existing customer that both increased utilization of its new production line, and significantly boosted sales volume and cash flow. Another bullet dodged, right? Yes – for a while. But the new problem now was that this customer had bet its future on a new product, one that quickly became obsolete with the advent of another product that quickly flooded the marketplace – the cell phone! So suddenly what was the company’s saving grace was now becoming the final nail in its coffin.
The point is, as I discussed in my previous article, “Heading Off Business Failure,” one of the most common reasons I’ve observed as to how businesses get into financial trouble is a major sales concentration with one customer. If anything happens to that customer, even if their payments on accounts receivable just slow up a bit, it can have a major impact on your company’s cash flow, not to mention what happens to your company if they go out of business completely.
In the case of this company, what it really needed was to increase sales and diversify its customer base, and find an investor to either purchase or capitalize the business to buy time. However, its sales concentration with this one customer also created an insurmountable barrier for prospective investors who were valuing the company based on “earnings,” and its asset-based lender finally ran out of patience. Consequently, the company was ultimately forced into a distressed sales of its assets, leaving behind a major shortfall on its asset-based loan – to be repaid by the owner, personally.