THE DEEP HOLE SYNDROME
How to dig out of a bottomless working capital pit.
By Ken Fowler

My parents often told me: "Be careful what you wish forÉit may come true." After spending eight years in the wireless telecommunications industry, to be followed by three years in the internet industry, all I wished for was a company that made a profit. My wish was granted but along with profits came the legacy of several years of aggressive, even risky, management of working capital. Effectively, the company had dug itself into a deep hole. Scrambling out of it turned out to be as essential to achieving sustained profits and healthy growth as reducing costs, improving sales and ensuring that we made great toys.

That's right, toys. Late last year, I accepted the CFO position for Zindart Limited, manufacturer of die-cast toys, pop-up children's books, board games, etc, as well as the owner of Corgi Classics. Along with many of the manufacturers in the toy industry, Zindart had extremely tough years in 2000 and 2001, leading to significant net losses. The company pulled through by leaning heavily on strained working capital management. This included pushing banking lines to the limits and stretching vendor accounts beyond the range of acceptability.

At the end of Zindart's fiscal year ended March 2002, the company had breeched its financial performance bank covenants, but had never missed an on-time payment to its bankers. Although the general relationships with the bankers remained healthy, the credit committees were pushing to tighten the trade credit lines, causing further working capital challenges. Also, the company had a hefty debt service requirement on its term debt (US$1.3 million per quarter).

For the current fiscal year, Zindart is profitable and the future is bright. For the three quarters ended December 2002, pre-tax profits were up US$8.7 million compared to the previous year. Although the company is certainly on the right track and the investors are happy, the challenges for management continue due to the Deep Hole Syndrome. Remember where the company started this year: tightening bank lines; stretched vendors and high debt service requirements. Although it has had healthy positive cash flow from operations, the cash has largely been used for debt service. Therefore, the effort to crawl out of the working capital hole continues.

The most evident impact from Deep Hole Syndrome is on gross margins. When bank lines are limited and vendors stretched, on-time receipt of raw materials is often difficult. Nevertheless, customers still expect to receive their orders on time. The production schedule is thereby reduced causing higher staffing levels, higher overtime, and increased use of outsourcing, all of which have a material impact on margins. Zindart management estimates that current year margins could have been up to 4 percent higher if sufficient working capital had been available.

The Bankers

Bankers are your friends, but they seem to be better friends when you don't need them. Building relationships with bankers can be a difficult process for new companies, since a new company has no track record on which the bank can rely. In many ways, the relationships are even more difficult to build for a company that has succumbed to net losses. Only in the past quarter have new banks begun considering new trade lines for Zindart. Many banks will want to see an entire year of profitable results before they will consider opening new lines.

The banks' reaction to Zindart's poor financial results was to tighten the trade lines. This was a natural reaction, and would seem to be the safe one. But given that a term loan was outstanding, one must consider whether this was the most prudent action. Consider a bank's risks related to a term loan. When the borrower's business thrives, the collection risk on a term loan decreases, and vice versa when a borrower's business languishes. Therefore, the logical reaction for a banker should be to support a customer's growth such that additional cash flows can be generated. But the banker has to first be convinced that operations have improved so that its additional support will generate a positive return. That is the banker's quandary.

The Customers

As the old saying goes: "Keep your friends close, and your customers closer". Collection efforts should be a process that begins before the initial customer contract is even executed. Basic understandings should be communicated from the start so that the customer appreciates our payment expectations. Often, warning signs can be discerned even in these initial conversations. Sales teams often do not like to broach this subject, as collecting on sales is considered a negative topic. But they do themselves a disservice if their commissions are based on collected sales.

Keeping your customers close can be a greater bonus when working capital is scarce. Customers can provide support in times of need by providing early payments, accepting more progressive shipment schedules, and providing letters of credit when none are required per the contract. On-time payment by a customer is never a favor; on-time payment is an obligation.

The Vendors

The key to profits is to buy low, sell high. The key to managing working capital is to collect early, pay laterÉsometimes much later. I always try to place myself in the vendors' shoes. Generally, they are trying to do the same thing that I am; that is, collect early.

Vendors provide our lifeblood, so we do not want to make them too unhappy. As with customer relationships, close vendor relationships can be key. To an extent, vendors are like bankers; that is, their comfort level increases if they understand your operations and your profit equation. A comfortable vendor is more likely to allow payments to age longer before strong-arm collection tactics are used. If vendors understand that working capital issues are temporary, they are often likely to work with the customer, building the long-term relationship.

Also, consider the vendor's product. Vendors of commodities are more likely to allow delayed payment than vendors of specialty items. Commodity vendors realize that a customer can always go to the next store in line.

For Zindart we have found that honesty is definitely the best policy. We have been open with our bankers, customers and vendors. They all know of our past failures. This is public information since we are listed on NASDAQ, and bad news travels fast. We cannot be sure that they know of our achievements in the current year, so we enlighten them. But we are also quick to explain that we are digging out of the deep working capital hole.

This approach has helped Zindart create new bank lines, successfully solicit early payments from customers, and carry some over-due payables for a while. In the near term, with continuing profitable operations, we will be completely clear of the Deep Hole Syndrome.

Ken Fowler is CFO of Zindart Limited, a Hong Kong manufacturer of die-cast and other toys