Monday 2 April 2012

Use of Fixed Charge Cover to spot a customer going bust?

Given the financial turmoil of the past three years resulting in further retail casualties such as Game Group, and a number of others on the brink, it is obvious that the ‘usual ratios’ such as ROCE, Net Margin, Stockturn and Gearing may be insufficient in terms of providing early warnings of trouble for suppliers.
What makes a retailer vulnerable?
A recent article in flags up the fact that if a retailer leases rather than owns its shops, it is faced with regular fixed charges for rent that must be paid, irrespective of the level of sales and profits. Moreover, if a retailer also has fairly high gearing, the interest payments represent an additional fixed cost on the business.
These Fixed Charges are ‘Lease costs’ and ‘Interest on borrowing’ and need to be compared with the ‘available Operating Profit’ i.e. the Operating profit less Fixed charges.   (these can be found on the P&L ('Interest paid' and 'Operating Profit') and early in the Notes to the Accounts ('Lease expense'), after the Balance Sheet
(NB when you find the figures, check them with your finance colleagues). 
In other words, the Fixed Charge Cover (FCC) indicates the ability of a company to pay its Fixed Charges, irrespective of sales and profit performance. Failure to pay can result in liquidation.
The following analysis compares the ‘big four’ multiples in order to illustrate the calculation in practice.
Given that these are the most financially healthy retailers in the UK, other retailers could be vulnerable..
Some of the differences are interesting in that, for instance Morrisons, because it owns most of its shops, and has relatively little borrowing, combined with a good net margin, means that with an FCC of 13.3, Fixed Charge Payments are no burden to the company. However, in the case of Tesco and Sainsburys at 2.9 and 2.2 respectively, FCC is obviously more of an issue.....
Application to other retailers?
However, the real value of the ratio is in its application to most medium and smaller retailers that are running short of cash and are finding that Fixed Charge Payments are pushing them to the edge….
As in all cases of pending liquidation, those creditors that are first to spot the danger, can have the advantage of withdrawing their credit before the liquidator is appointed.
Ignoring the Fixed Charge Cover indicator?
If you still feel that all such matters are the responsibility of the Finance Department, remind yourself that if a customer goes bust owing you £150k, and your pre-tax net profit is 5%, you will need incremental sales of £3m to recover…
In which case, perhaps the application of Fixed Charge Cover analysis to your customers’ latest Annual Reports will help…?

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