Friday, November 12, 2010

No. 18: Problem with a Rapid Growth in Business (November 12, 2010)

A long-established company in the bedclothes industry applied for court protection in Japan. This company achieved a rapid growth thanks to its strategy to introduce high-end bedclothes bearing the names of famous fashion designers into the market, that is, it successfully imported fashionability to the bedclothes business. The story of this company from the beginning of the rapid growth to the bankruptcy tells you about the high risk of high-cost structure common to the brand business besides disclosing the inability of this company to foresee the change of consumer behavior and the dynamism of distribution channels. If a company pursues economies of scale incessantly to achieve a rapid growth without improving the high-cost structure, it will face a big problem soon or later.

Economy does not seem to recover immediately in industrialized countries. In this condition, many companies hastily try to reduce production cost by means of economies of scale to satisfy consumers’ demand for low commodity prices. Capital investment to increase production capacity is vital to economies of scale. Expanding production capacity in a short period of time usually means a big increase of debt payable. Increased debt payable increases interest payment, and naturally, decreases capital adequacy ratio. Because unlisted medium-sized companies cannot procure capital in the market, they have only two ways to procure capital. Management executives increase the capital by themselves, and the company saves net profit after tax. Knowing the risk of increasing interest payment, most companies are enchanted by a rapid sales increase without improving the high-cost structure. And they diversify their business to get quick returns and increase the number of distribution channels.

In short, rapid sales increase by means of economies of scale alone decreases the capital adequacy ratio. If you build a new plant, expand facilities, and install new equipment, you have to come up with increasing expenses associated with the increasing production capacity and increasing stocks not to mention increasing labor cost. That is, repayment of principal and interest grows bigger and capital adequacy ratio decreases. In these conditions, a company has cash-flow problems and a high probability of bankruptcy due to a sudden change of business environment even though its results are in black. This situation is symbolized by a medium-sized company that achieves a rapid growth, builds a fabulous company building, increases production capacity, employs a large number of new workers, and suddenly faces financial difficulties because of a sudden business slowdown.

If a company faces this situation, it had better be realistic and avoid business beyond its capability, namely abandon the idea of expanding the business and take only highly profitable orders, and reduce the amount to settle by draft. Reducing settlement by draft improves cash management and increases the capital adequacy ratio. Generally speaking, if a company increases the capital adequacy ratio to above 30%, it can settle purchases only in cash. As the same time, it is necessary to abandon very small customers by following the four principles. They are not to sell on credit, not to give discount, not to deliver an order, and not to pay a visit for sales activities. Always, you have to keep in mind the risk associated with a rapid business expansion.

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