In this article, I use the internet marketing discount coupon site, Groupon, (see: Oh – the Shrinking Cashflow!) to illustrate an example of working capital deficit. Below are the reasons why I chose that company as the case example for this article.
The article contains lots of good keywords that are "hot" in search engines, and these bring more people to our site. (Attention)
Groupon is well known, so many people would be interested in them. (Interest)
It offers an excellent example of a problem experienced by some rapidly expanding "service" and "high turn" companies. (More interest)
Their whole story is a great case study model to follow; it is about an issue that some owners of young businesses are painfully facing. (Desire)
Since the article is about a company readers know, they will learn about the concept of working capital deficit and retain the importance of the issue. (Value)
We hope readers like the material, look around the site, and decide to come back for more. (Action)
I learned some time ago to work hard to make sure that every tactical action addressed multiple strategic goals. The article is a tactic. Perhaps we caught some attention. Getting traffic to our site is one of our strategic goals, and so the tactical selection of subject matter and story content is important. Analytic results show that, like our article on Quiznos, the article continues to bring in readers. We did not see any comments about the article, so we don't know how much value the readers got. We are not even sure if they actually learned anything about the concept.
So I give the tactical article a "C" grade for reaching the strategic goals.
Now, I share this minute detail with you in order to make you think about some of the news about Groupon. It appears that Henry Blodget and others made a lot of noise, and got under the skin of Groupon CEO Andrew Mason. Mr. Mason wrote an internal memo to the Groupon staff to counter the bad press and update the troops. That was exactly Mr. Mason's job as a leader—to keep the team informed and counter the bad news. Perfect.
Perfect… except for two things. One: would most of Groupon’s employees understand what Mr. Mason was saying in the memo, let alone read the whole thing? Two: if Point #1 is far-fetched, then who was the real audience for the memo?
Wait a minute. You ask how I know about the memo. Well, the memo was promptly leaked to All Things D, and you can read it here.
And that is a problem. In the land of "going public," there is a rule called the "quiet period," which is the period following the filing of the company's S-1 but before SEC staff declare the registration statement effective. During the "quiet period," the ability to discuss or promote the upcoming IPO by the stock issuers, company insiders, analysts, and other parties is legally restricted. That means that while Mr. Mason could write the memo to his employees, that memo should not have been made public.
Ouch. You could claim that some employee who did not know any better leaked the memo to a friend, who sent it to another.... well, you get the picture. So it looks like Groupon reevaluated the timing of its decision to go public and canceled the investor roadshow it had planned.
All that is just noise and bluster to us. Our real point is to highlight the concept of working capital deficit, which, contrary to Mr. Mason's assertion in his memo, is not always a good thing to have.
Here is an example to think of.
Assume you have $1 million of working capital in cash. Your monthly operating expenses are $150,000.
You are able to secure inventory of a product worth $500,000 under purchase terms of 30 days from time of invoice/shipment.
You are able to process the inventory through the supply chain and into the hands of your customer and collect the cash in a cycle time of 20 days.
Demand is solid and moving at a $500,000 per month clip. You sell everything you buy in 20 days and pay in 30.
You get to hold the cash for 10 days and then pay the invoice.
And you got a 10% net post-tax profit in the transaction.
If the market demand stays the same, prices stay stable, and you are able to keep turning the inventory faster than you have to pay, you get huge positive cash flow. You are not in a working cash deficit.
Now let’s add a plot complication. Demand grows to $850,000 per month, and you have to feed it with more working capital in float. You now have $850,000 in inventory with the same terms and turns. Life is good.
Then something happens. Suddenly, demand drops to $200,000 per month, and you have $850,000 in the pipeline. Now, where you had one month of sales in inventory, you have 4.25 months. You do not have the 10 days of net negative inventory, and you have to work off the excess. That is fine, except you have to pay for the $850,000 in inventory. Good thing you had the $1 million in cash in your working capital account.
Cash flow will be tight.
You pay the invoice for $850,000 and collect $275,000 in revenue (pay taxes later). Your $1 million cash balance drops to $150,000 after you pay the bill, and rises to $425,000 after you recognize the revenue. You still have cash to pay your $150,000 in other monthly expenses. Your cash balance ends up at $275,000 after expenses.
In month two, you sell another $275,000 in revenue (again, defer the taxes) and your cash balance goes up to $550,000. Take away the monthly expense of $150,000 and you close out the month with $400,000.
In month three, another $275,000 in revenue rolls in, and the cash again grows to $675,000. Net the monthly $150,000 expense, and you now have $525,000 in cash.
And so it goes, slowly building back $125,000 per month. Not bad. Tight, and a bit scary, but you survive—because you had the cash to work with.
Now imagine that you had spent that working capital on something else - like some other inventory, or some systems, and your cash balance is only $500,000. Now you have a serious working capital deficit.
You pay the invoice for $850,000 and collect $275,000 in revenue (pay taxes later) Your $500,000 cash balance drops to -$350,000 after you pay the bill and rises to -$75,000 after you recognize the revenue.
You have no cash to pay any other bills. The bank tells you that it will not honor checks. Now, the bank is willing to loan you the money… if you are willing to put your inventory up as collateral.
What do you do?
Here is a point to ponder. If you are making a profit, and you have a tangible asset to use as collateral, you can use the finance cash flow from the bank to rescue your company. Yes, you pay interest, but still survive. What does Groupon do? They do not have tangible assets. They own no inventory, they only have the accounts receivable from the coupon buyers that flows in sooner than the accounts payable they owe their "customers." If the company cannot earn higher profit to build cash position, they must source other cash, either from loans or investments.
And that is why they needed an IPO. Stat. The only way they could convince investors was to get the news out that they were making a profit and that sales would continue to increase (the "demand is growing and we are making great margins" argument that Mr. Mason made in his memo). That was that memo we should not have seen under SEC regulations.
How much do you know about the Operating Cash Flow (OCF) of your company? Is the OCF sufficient to support the business, or does the business need increasing levels of Finance Cash Flow (FCF) from the bank or Investment Cash Flow (ICF) from investors just to survive? Do you know where to look?