At the end of the line?

Case study:Having made some classic mistakes in the financing and development of his business, John O'Reilly must now try to find a way out of the darkness and into a place where his plastic components business can regain its footing in a relatively niche market - but how?

ENGINEER JOHN O’REILLY set up his company in the late 1970s making plastic components for a variety of domestic industries. During the 1980s the business grew strongly on the back of supplying the numerous automotive components companies operating in Ireland at the time.

As this industry began to decline and the IT and healthcare sectors began to grow, O’Reilly was quick to upskill his workforce and to invest heavily in sophisticated new equipment that could produce intricate parts for these burgeoning industries.

Today ORC employs 22 people and had a turnover last year of €6.4 million. The bulk of its sales are to the Irish-based subsidiaries of multinational companies but it also has a number of contracts in Europe with original equipment manufacturers.

The company has been consistently profitable since its formation. O’Reilly believes the best way to ensure it stays this way is through consistent capital investment so it can compete for contracts at the highest level. His company may be a relative minnow in European terms, but it has an excellent reputation for quality and innovation within its chosen niche sectors.

O’Reilly was delighted when he was invited to pitch for a significant European contract against much bigger competitors. In terms of turnover, this contract had the potential to add at least €1.5 million in sales per year for the following five years. However, there were both plusses and minuses to the contract, which had to be taken into account. All were discussed in detail by the executive team.

The financial controller Brian Quinn pointed out that the near 25 per cent increase in turnover was attractive not just for the sake of volume growth, but because it would make a large contribution to meeting the company’s not inconsiderable fixed running costs. That, in turn, would potentially increase the profitability of the entire operation in terms of its gross operating margin, then running at around 8 per cent of sales.

On the other hand, it would require an upfront investment of close to €250,000 in a new piece of equipment, as well as having other implications for working capital requirements.

Joe Fitzroy, production manager, concluded that taking on this contract would require a reconfiguration of the existing plant and the reassignment of the most experienced staff to the new line. This would have a knock-on effect on two of the existing production lines and would have implications for existing staffing structures. Fitzroy pointed out that, apart from the cost of the physical changes, the contract would also require the appointment at least two new team leaders with implications for salaries.

As the team worked on the tender proposal, O’Reilly became increasingly excited. It dawned on him that, although this contract would represent a slightly new direction for the company, it could also open up further new opportunities with its established clients.

When the various components of the tender proposal finally came together the cost, and crucially the cashflow, implications were greater than O’Reilly had anticipated. The financial controller was recommending that their minimum tender price be higher than he believed was realistic. He had already received positive feedback from potential customers and was determined to put in what he considered a competitive bid to secure the business.

He was delighted when word came through that they had won the contract and immediately focused on the many activities needed to get things moving. He even managed to put out of his mind the way Quinn had raised his eyes to heaven, hoping out loud that they wouldn’t live to regret the decision.

So six months later, O’Reilly was not unduly concerned when Quinn presented a pessimistic finance report at the weekly executive team meeting. Cashflow was weakening, he said, and this could be the start of a trend. However, when Quinn presented his report at the board meeting a few months later, the evidence clearly showed that ORC had fallen headlong into the trap of over-trading, with available profits being used to service various lines of credit.

The board demanded an instant review of cash management, something Quinn was relieved to be asked for. It showed that ORC had made a number of classic mistakes.

The new machine had actually cost €325,000 – not the estimated €250,000 when the contract was sought. This was because O’Reilly had taken it on himself to specify a more sophisticated model, offering more flexibility.

Defending himself, O’Reilly told his fellow directors: “You know investment in technology has always been crucial to our success. I simply took the opportunity to invest in something that would give us more opportunities with more customers in the future.

“The manufacturer would only give 10 per cent on the base model, but I got a 25 per cent discount on this one plus a two-year no-fee maintenance contract. It should have cost over €430,000, so I got an excellent deal.”

Quinn’s report also highlighted a deterioration in stock turn on raw materials. Upon investigation, it turned out that, with O’Reilly’s encouragement, the production manager had availed of bulk discounts on a number of raw materials.

This had gone unnoticed at the time by the accounts department because they thought it was all part of the additional stock required to handle the new contract. But for some materials ORC now has sufficient supply to see them through six months of manufacturing.

The new business O’Reilly had confidently expected to bring in once new the equipment was in place had still not materialised. Clients he talked to were still claiming to be interested in this new capacity but the evidence produced by Quinn showed that these same customers were actually extending their credit period. In fact, the average number of days credit being taken by debtors had deteriorated from 63 to 70 days.

On the other hand, O’Reilly had always taken the view that retaining good relationships and trust with suppliers was critical to business success, and for him keeping strictly within agreed credit terms was an important and tangible evidence of this commitment.

While understanding his position, Quinn said there had been times recently when they had been forced to make late payments, albeit by only a week or so at most, as a result of the delay in payments by debtors.

Cash was tight, furthermore, because of the servicing of the borrowings related to the investment in new equipment and on stock – both raw materials and finished goods.

As Quinn explained to the board, when taken together the small deteriorations in each of its key financial ratios, especially its stock turn and creditor days, were resulting in a significant negative impact on cash flow.

When Quinn prepared his working capital projections at the time the company pitched for the new business, he had prepared both best and worst-case scenarios. But he had been swayed by O’Reilly’s optimism about additional orders as a result of the acquisition of the new machine and had not had full knowledge of the subsequent bulk orders for raw materials. The out-turn, therefore, is that liquidity had deteriorated much further and faster than even he had anticipated it might.

The bank has been informed of where the company now stands and steadfastly maintains that it will have to operate within its existing facilities.

Quinn and the board believe some financial restructuring of the existing debt could be warranted because the fundamental business remains sound. In the current economic climate, however, chances of getting a sympathetic hearing seem slim.

The experts' advice:

ORC's problems reflect a management team that has failed to adapt and a board of directors that has failed to assist them in that process.

Financing growth in these troubled times is challenging. Worse, transformative opportunities such as the European contract in this example can actually become a millstone. This company needs cash – and quickly.

The first trick is to finance the new contract. An overseas contract with a good credit risk is probably something that can be monetised. For example, banking facilities could be sought in the city where the overseas company is headquartered, creating new opportunities to borrow cash and diversify funding sources. Relying on the Irish banking system is a high-risk strategy in the current climate.
In the absence of an overseas credit line, one could attempt to renegotiate the timing of the cashflows under the new contract or seek additional credit facilities in Ireland. Assuming the credit risk associated with the new contract is lower than that of the firm as a whole, this should be used as a basis for seeking additional borrowings. Further possibilities might include transferring the contract to a new operating company, along with some of the associated resources (for example via a lease). The new operating company could secure debt or equity investments as a standalone entity.

Aside from additional finance or investment by the owners, ORC must reconsider its working capital investments. The increase in raw material inventories is deeply worrying. This suggests a complete absence of internal control. If the raw materials are in excess of anticipated needs, then the company should consider liquidating the inventory or seeking additional credit lines from suppliers. The inventory might also present an opportunity for a secured lending arrangement.

The other element of working capital investment is accounts receivable. In the current climate, any increase in the credit period requires urgent attention. This is a signal that either the company's credit control function is underperforming or that customers are in financial distress. As all companies invest more resources in credit control, a failure to invest time and energy in harassing customers will mean that ORC is the last to be paid.

If the credit control function is performing well, an increase in outstanding credit signals that customers may be in difficulty. Senior management should make it a priority to investigate the health of the firm's customers and make contingency arrangements for the failure of major customers. It may also needs to reassess the company's strategy.

ORC's problems are similar to those faced by many companies today. The solutions are to explore new sources of finance by developing new banking relationships in foreign countries and identifying assets that may be monetised (for example, money owed by customers with a high credit rating, or inventories that may be sold in liquid markets).

However, ORC's problems also reflect a management team that has failed to adapt to the new reality and a board of directors that has failed to assist management in that process.

– Eamonn Walsh

ORC HAS the hallmarks of a former sole trader which, as it has grown, has failed to put in place a robust governance framework. As a result, it appears to have fallen into a number of traps.

Management has largely abdicated its responsibility by permitting O'Reilly to take decisions as he sees fit. To rectify this, ORC should introduce a formal governance structure where all projects over an agreed value are brought to the board. A control should be introduced to ensure major capital investments are only made on foot of a signed off business case, and dual management sign-offs be required.

A detailed business case should be developed for all major projects and investments. While ORC currently appears to be doing this, a robust financial model should be prepared. In preparing such a model, relevant input should be sought from a cross-section of the business. Where a business case assumes new market opportunities will open up as a result of the project, consideration should be given to conducting appropriate market research.

All projects should be presented to the board for approval where the recommended tender price identified by finance is overridden. The rationale for approving the business case should be formally documented.

Management also needs to address why the current situation was not identified earlier, with more focus on regularly monitoring the performance of the business. As such, a performance dashboard should be prepared, made up of relevant key performance indicators and presented at regular executive and board meetings for review. Appropriate working capital metrics should also be monitored by management to enable action to be taken to address deteriorating debtor days and determine whether there is an opportunity to negotiate improved terms with ORC's key suppliers.

To correct the current situation, ORC needs to make a number of changes. More robust controls and procedures need to be put in place and both board and management need to be more active in monitoring the performance of the business.

– Garrett Cronin

TAX IS A cost for every business and where managed effectively it can make a contribution towards freeing up cashflow. Where a business such as ORC is facing a challenging financial environment, it is more important that tax is managed effectively and efficiently. In particular, ORC's difficulty stems from overtrading and, though it has cashflow difficulties, it could be generating paper profits for tax purposes.

There are many ways a company may manage its tax burden – often simply by identifying and utilising available reliefs. Four main areas could be looked at:

1. Capital allowances on new machine

Depreciation is not tax-deductible, but a tax deduction known as a capital allowance is allowable whereby the cost of certain items can be written off against the company's corporation tax liability over time, usually an eight-year period. It is likely the machine purchased for the European contract would qualify for such capital allowances and could help reduce ORC's corporation tax liability.

2. Research and development tax credit

A tax credit of 25 per cent of any expenditure incurred in relation to research and development to "achieve scientific or technological advancement and involve the resolution of technological uncertainty" is available to companies.

Where ORC carries out such activities, perhaps in relation to the new machine, it should be possible to claim this credit. Any excess of the credit, not utilised in any given tax year, can be carried back to previous periods, forward to future periods or refunded over a three-year period (with certain restrictions).

3. Reclaim VAT on bad debts

Quinn notes that the average number of days credit being provided to debtors is increasing. It is likely that bad debts are also increasing. Where a debt has become bad, it can be possible for a company to seek a refund of any VAT previously been accounted for on the sale to the debtor and ORC should investigate this possibility in relation to all of its bad debts.

4. Engage with Revenue

In light of the challenging economic times, the Revenue Commissioners recognise that many businesses could have short-term cashflow difficulties which make it difficult for them to discharge their tax liabilities on time. Where the cash flow difficulty does not bring the viability of the company into question, and where the taxpayer engages with the Revenue Commissioners as early as possible, the Revenue have in our experience been willing in certain circumstances to work with taxpayers on the issue and show some flexibility.

– Ursula Tipp