Monday, 11 April 2011

Retail woes and the 'Working Capital Trap'

The retail sector has made the headlines for all the wrong reasons in the past month. Sainsbury’s has missed sales forecasts, HMV in trouble with its banks, and Oddbins has gone into administration.

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
--------------------Trade payables:£442m
-------------------------Other liabilities: £67m

The capital that sits behind a company is like the structural support holding up a skycraper. Equity capital is like the foundations on which the company is based; debt finance the reinforced steel beams allowing the tower to reach for the sky. The balance between equity and debt is critical. If you build too high without solid foundations there’s a risk the whole building could collapse – especially if the wind blows too strongly.

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.

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