Working in private equity there is always a strong focus on free cash flow (FCF) as a key performance indicator of the financial health and performance of the business so I have set out in this blog a brief description of what FCF is and some of the methods I have used with retail clients to help preserve or enhance it.
What is FCF?
FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.
Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like “free cash flow for the firm” and “free cash flow to equity”, which are adjusted for interest payments and borrowings.
In the following sections we look at three ways to improve free cash flow in a retail business.
Options for improving FCF in retail:
Defending or preserving FCF positions over the past year has been a key theme in bricks and mortar retail. Three key strategies that we have deployed in assisting retailers through this period have been renegotiation, stock & range optimisation and assessing the way in which you pay for and finance the business. We discuss each of these in the sections below.
Over the past year bricks & mortar retailers have had to shut-up shop for many months with the consequent drop in sales hitting the top line dramatically. Whilst furlough schemes and government loan packages have taken much of the sting out of this situation the bricks and mortar retailers have still been left with hefty rent bills to pay. This has resulted in the closure of a number of prominent retailers who were not able to service the rent obligations on their retail estates but it has, and because of some of these high profile closures, presented the opportunity for renegotiation of terms. Landlords have found themselves moving rapidly from a position of strength to that of weakness faced by the fear of a systemic abandonment of the high street.
Change of tenants is a risky and expensive time for landlords due to the need to invest in their properties to attract new tenants, the potential for void periods, the need to employ various types of intermediary to handle the process of getting new tenants in place and the temporary devaluation of their estates due to lack of occupancy. In situations such as the one we have seen for the past year, there is the added threat of systemic vacancy where swathes of the high street are unoccupied and become run down which puts off new would-be tenants and makes it harder to command market prices per square foot. For all these reasons it is preferable for landlords to maintain existing tenants than find new ones. The tenant in turn can press home their advantage by obtaining a better deal for the remainder of the tenancy which can have a major positive impact on FCF. This might include the introduction of a new and substantial rent free period as well as lower rent and better terms such as around dilapidations and other charges that may be levied during or towards the end of the tenancy.
There are clearly a number of other areas that renegotiation can be brought to bear turning the current difficult trading period for bricks and mortar into an advantage. This might include renegotiation with suppliers around the price of their products, the payment terms (which we discuss below) or the overall value and investment that they make in the products that retailers sell e.g. through rebates, investment in promotions etc.
Stock & range optimisation
Stock and range optimisation has been a key tactic for retailers during the past year and vital to preserving profitability and cash flow.
Ostensibly this relies on a very accurate understanding of the most and least profitable products. It is important to also understand at an SKU level how fast each item is moving and what the future demand profile might look like and also to have the ability to rationalise the range on a relatively short term basis. Once this information is clear it is possible to systematically work through your SKUs eliminating or reducing the low profit items and placing more reliance on a shorter list of winners. This can then feed into the levels of inventory held which can then be reduced to release cash. An issue with this approach however is the ability of the supply chain to respond quickly to short term changes in demand otherwise too little stock can result in out-of-stock which will of course impact the top line. Old and obsolete stock is another area where cash benefits can be achieved through converting these items to cash through heavily discounted disposal and the second order benefits of freeing up shelf space and warehouse space.
Methods of payment and financing the business
In the same way that rent negotiation has been a big opportunity for retailers to preserve or enhance free cash flow so the same is true of methods, timing and financing of payments and receipts out of and into the business. This of course refers to the negotiation of better payment terms with suppliers which ideally can be pushed back to beyond the time at which the money is received for the item being sold. This is easier in grocery than fashion particularly where the latter is built around a business with long lead times but it is still possible to gain some advantage from supplier negotiation in most circumstances. Added to this are the ability to use trade finance solutions provided by governments around the world and also a variety of financial institutions. This can help preserve cash in the business although will result in lost margin. Invoice factoring is of course the other side of some of these longer payment terms and the explosion of new providers in this area in the past few years has been a huge contributing factor to the ability of retailers to get better payment terms from their suppliers in the first place.
There have been a variety of existing and emerging new methods of preserving or enhancing FCF in a retail business over the past year that have been put to good use in helping businesses to navigate the tricky waters of lockdown and social distancing. These will stand the sector in good stead for the future and will be useful strategies to deploy during inevitable future downturns. 4C Associates is well placed to assist companies in these areas and others related to cost, profit and overall operational efficiency.