The Slippery Slope, Part Two
The Case for Early Intervention
In Part 1 of this article, we reviewed the business dynamic that leads to erosion in collateral values when a retailer with an asset based loan backed by their inventory experiences an unplanned sales decrease. We demonstrated that the cause is directly related to how management responds to that decrease, and the fact that, invariably, when sales begin to slip, inventory levels don't decline at the same rate.
It is critical for both retailer and lender to understand that whenever actual sales come in below plan for several consecutive months that collateral values are at immediate risk, and will decline unless management takes immediate and uncompromising action. In this event, both the company and the lender benefit when outside expertise is engaged to provide an unbiased, independent perspective.
The Case for Early Intervention
Obtaining an outside perspective as soon as a decline in the sales trend is confirmed provides both the lender and the borrower a number of benefits.
1. An outside perspective, engaged at soon as slippage is detected over the course of several months provides management with an independent, factual assessment of the situation. Frequently, management is too close to the situation to fully perceive the risk. Their focus when the top line begins to slip is instinctively on the top line, and taking measures to stem the loss of business. Acknowledging the need to respond to the declining sales trend by adjusting inventories to protect collateral values is seen as acknowledging that their efforts at turning around the sales trend are not likely to succeed. Early intervention is critical to assure that management fully comprehends the risk to collateral values.
2. An outside perspective also provides management with a comprehensive plan of action to adjust inventory levels in response to a declining sales trend. In fact, such a plan will only rarely impact management's initiatives to reverse the sales trend. Reducing inventories to reflect the declining sales trend is in no way mutually exclusive of marketing initiatives to reverse the sales trends, unless those initiatives specifically call for expanding assortments and inventory levels.
3. An outside perspective creates the impetus for action to be taken at the moment of greatest financial strength and market position, before any further erosion takes place. Continuing to invest in inventory in excess of the quantity needed to support the new sales trend unproductively drains cash away from other uses. In fact, reacting aggressively to bring inventory levels in line with the new sales trend may directly generate the cash flow management needs to invest in marketing and other initiatives to reverse this sales trend.
4. An outside perspective provides both the retailer and the lender the best opportunity for protecting and maintaining collateral value
How can the spiral be arrested?
What specific action steps would an outside advisor propose?
1. Once year over year or comp store sales begin to slide, a prompt, sober assessment of the retailer's forward sales plans is essential. These forecasts must err on the side of being conservative. If the current sales trend is declining, then the forward plan must reflect an expectation that sales will continue to decline, regardless of any mitigating factors, until the sales trend actually reverses itself and shows increases.
2. As forward sales plans are cut back, ending inventory plans must also be cut back, to levels that are consistent with the revised sales plans. If the original sales plan and companion inventory plan reflected an inventory turnover goal of 3.5 annual turns, then the revised inventory plan must continue to reflect that goal. Frequently, when sales begin to slide, retailers accept that inventory turns will also slide. They believe that if they cut back ending inventory objectives the company will not be able to capitalize when demand once again picks up, that cutting back inventory will result in lost sales when sales begin to pick up again. However, in the face of a declining sales trend, it is not prudent to focus your inventory planning on minimizing the amount of lost sales once the sales trend is reversed. In fact, once the sales trend does begin to turn around, retailers can meet that demand with lowered inventory levels for a period of time, with minimal risk of lost sales.
3. Prudent reductions in planned ending inventories will likely result in an overbought and/or overcommitted position. Purchase commitments must be evaluated item by item, purchase order by purchase order, and where necessary, be immediately re-negotiated with vendors. It is critical that the retailer move quickly to restructure its commitments so that overbought positions are brought back into line as rapidly as possible.
4. Slower moving items, programs and categories must be identified and immediate action taken. Return to vendor privileges need to be aggressively reviewed and pursued to return slow moving or overstocked items. Where necessary, markdowns to clear out any remaining problem inventory need to be taken promptly. Waiting for a more favorable time to take these markdowns is not likely to lessen the level of discounting necessary to sell through this inventory. The retailer needs to take the hit immediately, and generate the cash.
5. Operating expenses need to be immediately brought into line with the revised sales plan, at a minimum. Variable expenses must be aggressively reduced. In the near term, when sales volume initially declines, the tendency is to treat many variable expenses as fixed. Further, fixed expenses need to be challenged. While they may not be purely variable, many "fixed" expenses are actually step-variable. Finally, inventory carrying costs must be clearly identified. As inventory levels are reduced, savings in inventory carrying costs must flow directly to the bottom line.
6. Cash is king, NOW! In an environment of declining sales, cash must become king as soon as the trend is identified. Quickly taking steps to conserve cash maximizes the company's flexibility and options.
7. It is absolutely critical that communications between the retailer and its vendors be timely, detailed, open and honest, and occurs at senior management levels. It must be communicated clearly to vendors that actions are being taken at this early moment, which vendors might interpret as premature, to address the decline in sales early, in a calm, rational manner, rather than later when the situation may have become far more dire.
Early intervention in the event of an unplanned sales decrease is an essential, but fundamentally, a reactive step. While it provides both the Company and the Lender the best opportunity for protecting and maintaining collateral values, it is not a proactive approach. In Part 3 of this article, we'll discuss why a proactive approach requires an assessment of the Company's ability to effectively manage its inventory and react to potential changes in demand prior to any decreases actually occurring. And the time for that proactive assessment is at the point of loan origination.
© Ted Hurlbut 2004