David Gilbert, refinancing expert and Partner at BDO LLP, warns UK manufacturers against the risks of overtrading in the wake of the recession.
Manufacturing SMEs have faced challenging trading conditions over the last few years, with consistently low output and order balances.
However, this is starting to change: BDO’s second quarter Manufacturing Outlook with EEF shows that companies in the sector are reporting the strongest output and orders balances in a year.
Confidence among small businesses is at its highest level since the first quarter of 2010, according to the Federation of Small Business’ Voice of Small Business Index, which also reports that 36.4% of small firms expect prospects to strengthen over the next quarter.
Despite this, there are still reasons to be wary, and I’d encourage cautious optimism among manufacturers.
Experience shows that small businesses – and manufacturing businesses in particular – can struggle with fast growth coming out of a downturn. Often facilities that have worked well for them historically don’t work so well when growth is rapid, in particular the need to fund a build-up of stock and work in progress as the order book increases.
Invoice discounting is a financing product much favoured by the manufacturing sector. Whilst this provides quick and much needed growth capital, manufacturers that use it need to recognise that they can encounter real problems as they grow out of recession.
A recent example I dealt with was a growing engineering company in the South East, turning over £5 million and employing 40 people. As orders placed by customers rose, and their complexity increased, the company’s invoice discounting facility did not generate enough cash to fund the significant increase in the build-up of stock and work in progress.
In their enthusiasm to increase the order book, management didn’t recognise this dynamic and took on far more work and needed far more working capital than the discounting of the debtor book could provide.
In this case, it was not possible for management to repair working capital, either through cash injections from stakeholders/third parties, destocking, refinancing, disposing of plant and machinery or by exploring better cash flow management. The working capital solution should have been exploring the problem with their financiers, not in the pre-invoicing of work in progress which led to serious repercussions.
Ultimately, the directors had to give significant asset backed guarantees to enable their financiers to support at a much high level. The business was saved; however, the future trading was needlessly put at risk by their practices, when open and honest communication would have been a much better option.
In this recovering market, manufacturers need to be aware of the dangers linked to overtrading. As the volume of orders increases, it’s important to project just what working capital is needed to fund your growing business and consider whether your lender’s facilities allow for such a rate of growth.
“If there is a working capital gap, discussing the problem with lenders is key, and managers may even be pleasantly surprised by their response. Rather than having to rein in growth, discounters may be able to provide an over advance of stock and work in progress finance.
I am not aware that such a financing product is offered by any asset-based lender at present, but as the economy starts to grow the first able to do so should have manufacturers queuing at their doors.
Growth, especially after the difficult market conditions that manufacturers have been working through, sounds like a wonderful thing, but make sure it’s not a poisoned chalice.
Capacity and quality control is one thing – adequate working capital is another.”