Jeff had always paid his suppliers promptly and given his retailers credit. In one way this was a cause of his failure – cash flow became a huge problem, but in another way it was a reason for his later success. He went back to market trading. He had no difficulty getting supplies – people trusted him. As a salesman he was good. On his first day back in the market he took £750.
When things were going well with Tickled Pink, Jeff took an interest in horse shows. Now his connections enabled him to get stands at County horse shows selling to female buyers. His suppliers gave him credit – they trusted him. Soon he was taking thousands of pounds a week.
Within 7 years of Tickled Pink going bust, Jeff managed to have his own major retail outlet again; he won fashion awards and became wealthy once more.
Questions
- Explain one possible consequence of a reduced overdraft limit for Jeff Pearson’s stores.
- Explain two possible reasons why giving credit to retailers and paying suppliers immediately might have caused problems for Jeff.
- Analyse the effect that changing market conditions may have had on the failure of Jeff’s fashion outlets.
- Assess the importance of cash in the short run, and profit in the long run, for Jeff’s businesses.
- Evaluate the importance of sales forecasting to Jeff in the management of his retail outlets.
1. An overdraft is a short term loan facility provided by banks in which the borrower can sign out cheques up to an agreed limit over and above what is in the account. Interest is charged on a day-to-day basis but only when the account is overdrawn. An overdraft is important to Jeff Pearson as it allows him the opportunity to buy in stock and then replenish his bank balance as he sells that stock.
A reduction in the overdraft limit inhibits the way Jeff operates. He would not be able to buy in stock so regularly (this is particularly important in the fashion industry) as he does not have enough scope to do so. He will have to wait until consumers or retailers pay him enough money to enable him to buy more stock. This may prevent him from seizing upon an opportunity to make profit.
2. Credit means allowing clients to delay payment for a period of time, often 30 days. In taking this risk, whilst at the same time paying suppliers immediately, Jeff runs the risk of having a cash flow problem. Not all retailers will pay within a month and this further exacerbates the cash flow problem, putting further strain on the upper end of the overdraft facility, and perhaps causing the bank to review the facility once more.
A business that was profitable now runs the risk of becoming unprofitable as, if the overdraft limit is exceeded, the bank will start to charge much higher rates of interest. A vicious circle ensues which becomes difficult to escape.
3. Changing market conditions can be anything from macro-economic changes such as increases in the base rate of interest or increases in taxation, to micro changes such as an increase in competition or rises in the price of raw materials.
The evidence cites the 1992 recession with consumers reigning in spending on fashion clothes. Interest rates rose to 15 per cent so that the cost of borrowing became ever more expensive.
For Jeff the reduced overdraft limit together with the hike in interest rates would have slowed growth down enormously. His ability to obtain stock would have been curtailed as he would not have had the finance to pay suppliers immediately, and they would soon stop supplying at all. The squeeze on consumer spending further reduced the cash inflow until Jeff couldn’t pay creditors and was forced into liquidation. Spending on fashion clothes is regarded by most people as a luxury area and in a recession consumers cut back on luxury item expenditure to spend only on necessities. History tells us that they also try to save more – to put money aside for the ‘rainy day’ they believe is coming. This is a form of self-fulfilling prophecy – the paradox of thrift, for those wishing to pursue this further.
When the market changes for the better, i.e. there is an economic recovery, consumer spending on luxury items will increase. The fashion industry is prone to peaks and troughs that run parallel to the state of the economy and this makes trading conditions difficult at times.
4. It is often said that cash is king. If a business has cash in the bank it can continue trading. Profit, on the other hand, can be delayed. Profit is sales revenue less all the expenses of the business.
Operating as a market trader, Jeff would have been cash rich – his customers would pay him at the time of purchase, and his overheads would be low. His profit would grow almost at the same rate as the increase in cash. When Jeff started supplying up to 600 independent stores, cash receipts would be delayed, whilst his policy of paying suppliers immediately would have placed enormous strain on his cash flow.
Almost all businesses pursue the objective of profit, if for no other reason than to put it back to work within the business. Clearly Jeff wanted to expand and to do this he needed profit to re-invest. When Jeff’s businesses were doing well he had both cash aplenty and profit to grow his business.
The importance of cash in the short run and profit in the long run can be best seen when businesses run into difficulty. Cash is a non-earning asset so it is often recommended that businesses should hold low amounts of it. When business is good this rule works well but when demand falls and revenue streams dry up, having cash to call on can mean the difference between failure and survival.
Suppliers do not operate altruistically – they need payment. Non payment soon reduces the supply of materials and finished goods. Without cash, businesses more often than not fold. Profit, the reward for risk, is a long term pleasure, to be enjoyed in the good times. Profit gives Jeff the chance to earn a good living, to have the nice things in life. If much of it is ploughed back into the business the chance of failure is reduced, but a lack of cash in the short term can have disastrous consequences.
5. Sales forecasting sounds simple – predicted units sold multiplied by the price. For an experienced business the job may be relatively straightforward but there are many factors to take into consideration in the process. For a new business, despite pre-planning, estimates are often wrong and sometimes by a considerable margin. At the same time as forecasting sales, entrepreneurs should also be forecasting costs, and therefore by definition, profits.
If forecasts are always wrong then why carry them out? For Jeff I expect the answer would be simple. He will need to estimate carefully the level of sales anticipated in order to source the correct amount of materials and finished goods in this ever changing market. Furthermore, having completed forecasting he is then in the position of comparing actual figures with the forecasts and then analysing the results.
His forecasts will have been built on a combination of historical factors – he has been in business a number of years, and on what he can foresee ahead; growth in the economy, for example. Comparisons made (variance analysis) will enable him to gauge whether his business is doing well, and also allow him to re-adjust his future forecasts in light of the evidence available.
Forecasting can be time consuming and expensive. For small traders it is another job to add to the list, and it doesn’t always get done properly. Larger businesses, such as Jeff’s will employ experts to carry out the research and should be able to make better judgements.
Forecasting is not an exact science. Whereas Jeff’s businesses were caught out in 1992 by recession, the ERM debacle and very high interest rates, many more businesses will have been damaged more recently by the banking crisis and inability to obtain loans, even at relatively low interest rates.
On balance businesses should always try to plan ahead and sales forecasting is part of that preparation. Whilst forecasting cannot prevent unforeseeable events affecting business, it can plan more effectively for the future and be in a state of prepared readiness to deal with endogenous and exogenous shocks.