August 08, 2012

De--Leveraging

In the banking world, when you borrow too much money and you fail, you go through a period of de-leveraging.  It is a painful process.

Our worldwide economy is about five years into a de-leveraging process.  Many of us lost jobs, or took a beating on home values, all part of a de-leveraging process.  It stinks.

This happens in our world, too.  You can tell by looking at a profit and loss statement.

Here's a summary of a reasonably healthy profit and loss statement.
  • Net Sales = $50,000,000.
  • Ad Cost = $5,000,000.
  • EBITDA = $6,000,000.
  • Ad to Sales Ratio = 10%.
Three years later, we see something like this:
  • Net Sales = $53,000,000.
  • Ad Cost = $8,000,000.
  • EBITDA = $5,000,000.
  • Ad to Sales Ratio = 15%.
Clearly, the business is struggling.  Sales have plateaued, so Management is spending a ton of money to keep sales growing.  This hurts profitability.

Three years later, the business is in trouble.
  • Net Sales = $55,000,000.
  • Ad Cost = $10,000,000.
  • EBITDA = $3,000,000.
  • Ad to Sales Ratio = 18%.
Here's the problem.  This business probably needs to de-leverage.  But when it de-leverages, it will be much, much smaller.
  • Net Sales = $35,000,000.
  • Ad Cost = $5,000,000.
  • EBITDA = $3,500,000.
  • Ad to Sales Ratio = 14%.
Can you see why Management would balk at de-leveraging?  The business shrinks by close to 40%, and profit barely changes!

There's two issues with this.
  1. Nearly $20,000,000 of sales is being generated for no benefit whatsoever.  Why generate sales that don't produce short-term or long-term profit? Be honest.
  2. What could you be doing with the $5,000,000 of ad cost that is not generating any profit whatsoever?
Answering the second question is critical.  What could you do with the $5,000,000 you are spending to generate no benefit whatsoever?

Most of us cannot answer that question, and for a good reason.  It's a hard question to answer!

As a result, we keep plugging along, hoping that something will mysteriously change.

It's pretty darn important to have an answer to the second question.

P.S.:  I cannot tell you how often I run into the "$20,000,000 demand and $0 profit" problem.  It's everywhere.  Your paid search people cause this problem, and your catalog circulation people cause this problem.  You mail so close to break-even or by paying for clicks right around break-even.  Now, I get it, you're theorizing that the long-term value of these decisions pay for themselves.  That may be true.  But what the heck else could you be doing with that money?  You could practically start a new business!  But nobody wants to lose $20,000,000 of demand that generates $0 profit.  And I know, you're going to start leaving comments with MBA theory about why this is a good decision.  We can agree to disagree.

5 comments:

  1. Anonymous9:50 AM

    This certainly raises other questions for me:

    Does $20M in sales with $0 profit hurt a company? Does it create or protect jobs without harm? Does it prevent another company from getting $20M in sales and hence lower competition? Is smaller better than larger if the profit is the same, or are there benefits to being smaller or larger? Or are there benefits to captuing more or less of a market?

    If I leave the $20M in sales for someone else, how will that help or hurt me (especially if it comes at breakeven).

    Maybe these are not relevant, but it seem slike a more complicated question than just P/L.

    ReplyDelete
  2. If you put 100 CEOs in the room, I'll bet 85 would start answering your questions and decide to continue business as-is.

    ReplyDelete
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