Cash Flow Revisited; Why Hardly Any Successful Business is Just Snowboarding Anymore

I know it’s because of crossover, and the mainstreaming of action sports, and because we’re selling to parents as much as to kids. I know all that. Largely, I believe it. I just did my occasional and not nearly frequent enough sojourn into a bunch of local snowboard retail stores, big and small, and looked at what they’re selling. Snowboards and snowboarding equipment, apparel and accessories- sure. But they are also selling skateboarding, surfing, skiing, wakeboarding, bikes, roller blades, tennis and/or some others depending on the time of year.

Have they become as diversified as they are because of “the market?” Yes, “the market” demands it. But lurking in the lichens is the financial requirement of businesses that are highly competitive and selling products that are awfully similar to each other in a given product category, differentiated largely by the brand marketing strategy. Bottom line is that the less seasonal your business is, the more money you can expect to make.
Let’s take a journey into fantasy land and take a look at a couple of hypothetical business that are in snowboarding (retailers or manufacturers- makes no difference) and see how their financial equations differ with the seasonality of their sales. I know you already know that it’s bad to be seasonal, and good to sell all year around. But the extent of the difference on the two company’s financial results-especially the return on investment- may surprise you.
Meet the Contestants
Seasonal Enterprises (SE) and Year Around Ventures (YAV) both sell snowboard hard and soft goods. But while SE sells almost exclusively snowboarding and snowboard related products, YAV has diversified into other action sports.
Both SE and YAV sell $12 million a year. SE does all its business in five months. YAV boringly sells $2 million a month, month in and month out. 
At the end of the year their income statements, down to the Income before Interest and Taxes Line, look identical.
Net Sales                                                                   $12,000,000
Cost of Goods Sold                                                 $ 7,800,000
Gross Profit                                                               $ 4,200,000 
Operating Expenses                                               $ 3,600,000
Income Before Interest and Taxes                        $     600,000 
Now, $12 million is kind of an awkward revenue number. It’s much more than your typical specialty shop sells, and it’s probably less than a snowboarding brand needs to do in revenue to break even (I think that number is maybe a little north of $20 million unless you have a very well established brand and market niche).
Just for your information, in their most recent complete years, Vans, K2, and Pacific Sunwear had gross profit margins of, respectively, 43.5%, 31.1%, and 33.5% of sales. Operating expenses, respectively, were 35.7%, 25.3%, and 22.7%. Unfortunately, no specialty shops publish their financial results.
This hypothetical income statement is kind of a cross between a retailer and a brand. The goal, however, is to make a point so allow me a little creative license as I set the stage to make it.
Balance Sheets and Working Capital
Working capital is the money you have invested in a business so that it can operate.   Rent, salaries, product costs all of which are incurred before you sell anything represent working capital invested in the business. To the extent that you can get terms from the supplier of the product or service you are using, your working capital requirements can be reduced.
The balance sheet shows, as a point in time, the financial viability of a company and its ability to finance itself. Let’s compare the working capital and balance sheet situation of SE and YAV.
Seasonal Enterprises
SE, you will recall, does all its business in five months. But it has to operate for twelve months, and buy the product it sells in a way that it has product to ship during its selling window. Assume its total expenses of $3.6 million are spent evenly over the year- $300,000 a month. In practice, selling and marketing expenses would be weighted towards its selling season.
It’s got to buy its product for a total of $7.8 million. Remember SE is getting some terms from its suppliers, but it may also be giving some terms to its customers. Where does that all net out in the real world?    Obviously it’s different depending on whether you’re a retailer or a manufacturer.
SE’s going to spend $300,000 a month for seven months before it sells a thing. It will probably collect some money from the previous season during this period, but it will also have some expenses that go out during its selling season before much comes in the door. If, then, it has to borrow $300,000 a month for seven months it will have $2.1 million in loans just for operating expenses by the time it starts selling. And of course you won’t pay it all off the day you start selling.
Then there’s the $7.8 million in cost of goods sold SE has had to finance. For how long? Shall we say four months?
The last prime lending rate cut was to 6.5 percent on August 22nd. Just to make my calculations easier, let’s say you are borrowing at 10 per cent. I know that may be high for some borrowers, but if we think about credit card fees (which I consider basically financing costs) letter of credit fees, commitment fees, etc. maybe it’s not too far off when you look at your real cost of borrowed capital- especially for smaller businesses.
If you assume you pay off the loan for operating costs completely literally the day you start selling, your interest charge would be $70,000. It’s more realistic to say you pay it off over a couple of months at best, so let’s say it’s really $90,000.
At 10% for four months, financing the cost of goods sold comes to $240,000. Total interest expense, then, is $350,000.
After interest, pretax income is $250,000. Assuming a 30% tax rate, the business earned $175,000 for the year, or 1.46 percent of sales.
Year Around Ventures
This is a little easier to explain. They just do $2 million in business each month. No big inventory buildup. No operating expenses to finance without any income.  They get some terms from their suppliers, and, with luck and depending on the type of business it is, may even collect before they have to pay. They don’t need millions of dollars in temporary working capital just to get through the business cycle. All they have to finance, more or less, is a month’s worth of expenses or maybe a little more. Their interest expense? Hardly anything. Maybe if they’ve got any sort of balance sheet at all, nothing. If that’s the case, and with the same 30 percent tax rate their net income for the year is $420,000, or 3.5% of sales.
Balance Sheets and Rates of Return
Income statements don’t happen in isolation from balance sheets. On your balance sheet, you (hopefully) show some equity- the total of the investment in the business plus the profit you’ve made, less any losses you’ve incurred, and less any dividends you’ve paid out. The larger the number is, the stronger the business is, and the less money you should have to borrow. So, you can truthfully exclaim, “If I’ve got a whole bunch of equity in my business I don’t have to borrow squat and I’ll have no interest expense! My return on sales will be the same whether I’m SE or YAV.”
True, but that’s a misleading and incomplete analysis. The financial issue is always what are you earning on the money you have invested (the equity in the company, more or less) and how much risk are you taking? Most simply stated, return on investment is net income divided by total equity. YAV, due to its year around sales, doesn’t need much equity to have basically no interest expense. It’s probably got a great return on equity, and because of the diversification that allows it to sell the same amount each month, it’s risk is lower.
SE, on the other hand, has to have a pile of equity if it’s going to eliminate its need to borrow money. If it does that, it will have the same net income at YAV, but it’s return on equity will be much, much lower. And its seasonality makes its risk higher.
As you consider your return on equity, be aware that if you’d invested your equity in an intermediate term bond fund for five years, you would have earned around eight percent a year before taxes. Over the last twelve months, with the Fed cutting rates, you would have earned something like thirteen percent. We can probably agree that the risk in an intermediate term bond fund is less than the risk of an action sports business.
In the market we’re in right now, is there any competitive advantage to being a “snowboarding only” business? I can think of a couple of possible exceptions but generally, I’d say probably not. If there was, it would be financially rewarding from a return on investment point of view. Isn’t it interesting how the industry’s requirements for success from a marketing and a financial perspective have come together?