How Middle Market Companies Can Avoid a Liquidity Crisis

How Middle Market Companies Can Avoid a Liquidity Crisis

By Matt Dallisson, 27/11/2023

This is no time to be caught short of cash, or long on inventory, or both: not when interest rates are double what they were a year ago and revolving credit is hard to find. Not when the International Monetary Fund projects that the world’s advanced economies will grow just 1.4% next year. Not when it’s harder than ever to predict and balance supply and demand, which were whipsawed by the pandemic and have not yet regained equilibrium. Not when the number of business bankruptcies, while lower than at the peak of Covid, is up 23% over last year.

Even short of bankruptcy, many otherwise viable companies could face a liquidity crisis caused by the combination of rising costs, pandemic-driven changes in customer behavior, lingering supply chain problems, uncertain sales in a wobbly business environment, and the nearly certain difficulty of finding short-term capital.

Liquidity is often seen as a problem for finance, but, in fact, operations play a leading role in preventing or addressing cash problems. Companies that revamp how operations, sales, and finance work together can generate cash and earnings before interest, taxes, depreciation, and amortization (EBITDA) — often quite a lot and often very fast. Strengthening sales and operations planning allows companies to take charge of their destiny regardless of external disruptions — which is a particularly useful capability right now.

Middle market companies have much to gain by making this transformation. We’ve seen companies improve working capital by 20–30% and increase EBITDA substantially in just a few months. One private-equity-owned manufacturer of vitamins and nutritional supplements, for example, saw a 10% gain in EBITDA largely by making its overseas sales and distribution (where most of its growth potential lay) more connected with manufacturing operations in the United States. That helped drive down production and shipping costs.

By the same token, the impact of poor sales and operations planning hits the middle market hard. That’s partly because these companies are disadvantaged if they need outside capital. In an AlixPartners’ 2023 survey, 96% of turnaround and restructuring experts said the middle market is most at risk from today’s capital constraints. Midsized companies are also threatened because they often sell to large multinationals, which increasingly use their muscle to pay suppliers later, in some cases trying to lock in easy terms they won during the pandemic. Because middle market companies tend to be less diversified, they are more vulnerable to shocks. And, because of their size, their “liquidity runway” — the time they have before a cash shortage becomes a crisis — is shorter than for big companies.

Every company has some kind of process for aligning supply and demand. In smaller companies, it’s often very informal: Sales comes in with a forecast, the CFO discounts it, production adds some back as a cushion, and every quarter people adjust things. Many have a more sophisticated process, but it tends to be rigid and unresponsive to weak signals from the market, which leads to fire drills in production, if business is unexpectedly good, and fire sales, if things fall short. In both cases, the emphasis in the process is on managing production smoothly, not on generating cash and margin.

What’s needed — especially by the middle market — is a transformed sales and operations planning process that threads the needle between informality and bureaucracy and gives executives the ability to adjust operations to increase cash generation and profitability.

This transformation has four elements:

An aligned team among operations, sales, and finance.

When these teams are aligned, they are  empowered with knowledge of how the company uses and generates cash. “Aligned” is the key word. Operations and sales planning should be managed in a cross-functional “war room,” but it won’t work unless all participants are explicitly motivated by items that affect cash generation and margin, which aren’t usually among the KPIs ops and sales track. In most companies, the operations team is measured on cost of goods, defect rates, machine utilization, and the like; sales teams tend to track and reward volume, with special incentives for promotions and so on. Those incentives should be changed to include cash and working capital measurements (e.g., days of inventory, average discounts, average days outstanding for receivables).

Forecasts need to be recast, too, so they model how predicted levels of production and sales will affect all three views of the enterprise: income statement, cash flow, and balance sheet. The team also needs an enterprise-wide view of liquidity needs, biggest threats to liquidity, and biggest sources of cash — that is, which products or lines of business consume or churn out the most cash. Those reveal what levers you can pull.

More rigorous and flexible forecasts.

It’s not uncommon for CFOs to cut the sales team’s forecasts by as much as 25%, partly because sales teams tend to be too optimistic and their predictions sometimes aren’t defensible enough. Another problem is their time horizon. In our experience, it’s best to build rolling mid-to-long-term (3–14 month) views of demand, use them to produce three-month forecasts that are solid enough so you can make purchasing and marketing decisions, and tweak them weekly or monthly. Too far out, plans won’t be reliable; too close in, you can’t act strategically.

Don’t forget — as many companies do — to use data on customer churn and loyalty to test, validate, and adjust forecasts. You’ll want to tune that view of demand in four ways: First, to get a clear picture of where cash and EBITDA are (and are not) coming from, build out a picture of profits as well as volume; you want to know which products and customers provide the most — and least — profit, and pay close attention to their orders and behavior. Second, as you should with your overall budget, create scenarios for the long-term view — for example, what high, medium, or low demand would be, or what would happen if sales suddenly skewed to the lowest-price or least profitable items you sell. Third, predetermine the indicators that would tell you whether a scenario is coming to pass; this will make it harder to ignore warnings. Finally, use monthly and quarterly reviews not just to track the forecast to plan, but to revalidate its premises.

A similarly rigorous map of supply.

The should include material, component, and labor availability. Among other things, you will want to identify components or supplies that have the longest lead times or where your knowledge of conditions upstream tells you to beware of price or supply shocks. Many providers help companies build supply chain “control towers” to track availability and pricing in near-real time, often with help from AI. These used to be the nearly exclusive province of multinationals, but they are now within the reach of most middle-market budgets.

Operations that optimize profitability, not predictability.

An operations plan that guarantees uninterrupted production of your least profitable products isn’t good. With the knowledge you now have about the profitability of products and customers, a better flow of information from the field, and an empowered cross-functional team, you can now exploit whatever flexibility your operations have to shift production from one location or product to another or prioritize orders from profitable customers. You can make analogous changes to inventory management. Viewed strategically, inventory can be a liquidity drain or a new customer-acquisition tool — “bad” or “good” inventory — and managed accordingly. Thinking long-term, you can reorient capital spending to increase operational flexibility in the areas that have the most direct impact on cash and margin.

A program like this released $17 million in working capital — a reduction of about 180 days — for a $2 billion-in-sales consumer goods company based in the Mississippi Valley. The company’s operations were knocked off balance after Covid wreaked havoc on its supply chain and caused demand to whipsaw, as big online retailers suddenly scooped up business from local shops. Its forecasting model was shot; unable to know where sales were coming from, one business unit was forking over nearly a million dollars in late-delivery penalties and air freight. Working from guesstimates, factories produced the wrong mix of products and procurement purchased too little of some components and too much of others, so that fill rates (the percentage of orders completed in full and on time) plunged from 95% to about 75%. To try to cover orders, the operations team stocked up $12 million more in finished-goods inventory than the company needed. Previous attempts to address the problem had looked at it piecemeal — at supplies and components, at production planning, at forecasting — rather than systematically. We worked with them to build a rough-cut capacity model that allowed revealed potential supply-demand imbalances months earlier than before; improve analytics skills on the forecasting team; and institute a monthly cadence of sales-and-operations-planning meetings that brought data and decision-makers into the same room.

Without a systematic view, the incentives and good intentions of each player in this game — procurement, production, and sales — will almost always pull it out of balance. The operations team is uniquely placed to bring the system together, because the pain is felt there first, in the form of stockrooms that aren’t being emptied or orders that can’t be filled. By the time the pain appears in cash and EBITDA, it’s late — sometimes too late.

This content was originally published here.