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From a profitability perspective, 2002 was the worst year in memory for most distributors. NWFA distributor members were not exempt from profitability challenges. In 2002, the typical return on assets (ROA) in the industry was 7 percent. ROA is pre-tax profit expressed as a percentage of total assets. The 7 percent rate scarcely justifies reinvesting in the business for future growth.
While the typical company has struggled, a few companies have enjoyed strong profitability levels. For 2002, the top-performing group of NWFA distributor members had an ROA of 15 percent, a profitability level that was 2.2 times the results for the typical company. In short, the industry has become two-tiered. That is, a lot of companies produce modest profits, and just a few produce strong results.
The disparity between typical and high-profit results should serve as a warning for typical companies. While very few companies are sanguine about the profitability gap, they frequently do view it as the inevitable result of a stagnant economy. The feeling is that as the economy improves, the rising tide will lift all ships.
A look at recent results and realistic projections regarding the future suggests that economic recovery alone will not close the profit gap. Instead, the disparity between winners and losers may continue to the point where it challenges the very existence of some companies.
In order to better understand the impact of a two-tiered industry, we need to look at two specific issues:
• A five-year projection: Most companies are not fully aware of the extent to which differences in current performance multiply over time and result insignificantly larger differences in only a few years. Here, we will look at just how important the difference between typical and high-profit really is from a growth perspective.
• The improvement challenge: Moving from typical to high-profit performance calls for improved results on several key measures. Surprisingly, the magnitude of the required changes is not large. However, changes need to be made in several areas of the company simultaneously. Here, we will look at the factors that need to be targeted in order to enhance profit performance.
A five-year sales & profit projection
Theoretically, every company can grow as fast as it can find customers. While sales growth may require an increased investment in inventory and accounts receivable, that investment can be financed through additional debt. In reality, however, the availability of capital for growth rests upon the ability of the company to produce a profit and reinvest that profit back into the business. High-profit companies possess a pronounced advantage in the quest for capital.
Figure 1 compares the current financial performance of two equal-sized NWFA distributor members—one typical and one high-profit. At present, the high-profit company produces higher profits, which gives it a short-term advantage. In addition, the figure looks at the two companies five years from now, when the advantage has been dramatically multiplied.
In order to address the impact of profit on growth, the figure makes a key assumption about profit reinvestment. Specifically, it assumes that both companies reinvest all of their after-tax profits back into the business. It also assumes that the companies continue to operate as profitably and as productively in the future as they do today.
Both assumptions can be challenged. After all, recessions do eventually end. When this one does, the typical company certainly will do better, but so will the high-profit company. As long as there are two tiers of results, the high-profit companies will always have an advantage. This is true in good times and bad.
The figure suggests that the short-term advantages are magnified in the long term. By the fifth year, the high-profit NWFA-member company has increased its sales by 38.8 percent using only internally generated funds. At the same time, the typical company can grow by only 26.6 percent. Over time, the high-profit company is not only increasingly successful in generating profits, but also is more successful in building a stronger market position.
Again, the typical company could borrow the additional funds required to maintain sales parity with the high-profit company. Ultimately, that strategy will fail because of two important reasons. First, an increasing percentage of profits must be used to pay interest charges, and an increasing percentage of the cash flow produced by those profits must go to pay back loans. Second, debt eventually becomes so large that there are simply no more lines of credit available to the company, even from the most aggressive lenders.
In short, the difference between typical and high-profit results is important today. Of much greater consequence, it is critical in the future. Companies must commit to making the journey from typical to high-profit. The question is how?
The improvement challenge
In most companies, there is a prevailing perspective that if profit is going to be improved substantially, the company must make dramatic changes in its operations. In motivational guru parlance, it must commit to "1,000 percent improvements." In fact, nothing could be farther from the truth. For several years, Profit Planning Group has espoused the philosophy that small changes in some key areas of the business can produce big results.
The latest NWFA report identifies the factors that drive higher performance. While no company is the best for every factor, high-profit companies have several key advantages, listed in order of importance:
• Gross margin percentage: The high-profit company produces a gross margin of 24.4 percent, compared with only 22.2 percent for the typical company. This is a gap that can be closed in two to three years.
• Operating expenses: The high-profit company has an operating expense ratio of 19.2 percent of sales, compared with 20.4 percent for the typical company.
• Inventory turnover: The high-profit company turns over its inventory 9.7 times, while the typical company achieves a turnover rate of only 6.4 times.
• Average accounts receivable collection period: The high-profit company collects its accounts receivable in 39.2 days, while the typical company requires 40.0 days.
These factors must be central to the planning activities of every NWFA member. Everyone on the management team must be focused on these factors. They must also be fully trained on how these factors impact results. Finally, every employee must be aware of the specific actions required that will lead to improvement on the key factors.
Moving forward
High-profit companies have an important profitability advantage over the typical company today. If the performance differences continue, the high-profit company will have an insurmountable advantage in the future. The typical NWFA member must start today to close the profit gap.
Calculating Future Asset and Sales Levels
Unless the company borrows money, the only capital available for growing the business is the after-tax profit that is reinvested back in the business. For the typical company, that figure was $119,000 in 2002. When this is combined with the existing asset investment of $2,439,024, the company produces a new asset base of $2,558,024. This new figure can then support higher sales. The typical NWFA member has an asset turnover ratio of:
Net Sales Ă· Total Sales = $10,000,000 Ă· $2,439,024 = 4.1
This means that every $1 of assets can support $4.10 of sales. If this relationship continues in the future, the new asset base of $2,558,024 can support sales of $10,487,900 ($2,558,024 x 4.1). Subsequent years produce the same increase in sales generated by more assets, which are, in turn, dependent upon increased profits.