Wondering what is behind these kinds of problems, I decided to take a look at HMV’s financial statements. An inspection of HMV’s capital structure at April 2010 is quite revealing:
Total Equity: £100m
Total Liabilities: £605m
-------Of which: Interest bearing debt: £96m
-------------------------Other liabilities: £67m
Retail businesses are unusual as their largest source of capital financing is their suppliers (‘trade payables’ above). Big retailers don’t pay their suppliers for 60 to 90 days after receiving goods, but when customers buy products they often get the money immediately. In effect, the suppliers are providing interest free loans. It is a form of ‘leverage’ which allows management to build a company on a thin slice of equity capital.
This business model works perfectly well as long as sales volumes are growing. The cash coming in from sales in any given month is higher than the amounts owed to suppliers for sales in the previous month. Sales can grow without the need for any additional equity investment. However, if sales stop growing, suddenly the amounts owed to suppliers exceeds the cash received from sales. The company finds itself in a ‘working capital trap’ where it suddenly needs to find a lot of extra cash, either in the form of an equity injection or a bank loan.
In its Annual report in April 2010, HMV was still showing revenue growth. But in its interim report in October 2010 it reported an 11.5% drop in like-for-like sales. The urgent need to find more working capital is what's thrown doubt on its ability to meet banking covenants, and caused it to seek further financing from its suppliers. I will be watching with interest to see how this story progresses - but I don’t plan on investing in HMV shares any time soon.