Metalforming Industry Insights

This is article is part of a series of monthly articles produced by Harbour Results for PMA’s MetalForming Business Edge e-newsletter. Click here to view the full collection of articles.

Don’t Capsize in the Brewing Collision of Storms

There are a number of storm fronts in manufacturing today. Weathering any single one of them may be difficult but nothing that manufacturers haven’t gone through before. The question is – will the collision of these fronts create a perfect storm that those who are not prepared won’t survive?

Storm Front One: Long Lead Times

The supply chain issues for raw materials that have plagued manufacturers since the pandemic has continued. Harbour Results surveys of metalformers, plastics processors, die casters and tool builders describe lead times on average continue to be about double the wait for raw materials seen in early 2020. The studies also indicate that manufacturers have compensated for the long lead times and volatile prices by keeping higher levels of raw material on-hand to meet demand. By doing so, manufacturers have tied up cash in their businesses, making less available for other expenses and investments.

Storm Front Two: Delayed Demand

Trusting manufacturers to be rational – ordering raw materials was not done speculatively, but because they saw demand that needed to be met. And there was. Demand for durable goods was very strong throughout 2021 and into 2022. However, if a component or material anywhere in the supply chain wasn’t available, or if labor was insufficient, the customer was forced to delay releases and orders from the metalformers, plastics processors, or die casters were not released to avoid overstocking inventory themselves. And facing their economic uncertainties, those customers have continued to be cautious to conserve cash by balancing a fine line between just-in-time component orders and the risks of not meeting the demand of their customers. This leaves the component manufacturers holding on to finished goods on top of slow-moving raw materials, thereby tying up even more cash in their businesses.

Storm Front Three: Rising Cost of Capital

Our studies reveal that average inventory turns have noticeably dropped for manufacturers in 2022 from 2021. There is a higher level of net working capital in the business, as payment terms have not changed from customers or suppliers to offset the higher inventories. While the average debt to equity ratio remains below 1.0, debt levels have increased – in some cases to fund losses, in some cases to fund growth, and in some cases to fund this increase in working capital. While historically speaking debt is still relatively cheap, the price of that debt has increased substantially in 2022. The Secured Overnight Financing Rate (SOFR) which is the basis for many credit agreements has increased from 0.05% in February to a high of 2.3% in August. The interest payments on any debt-funded working capital have increased, which is not only an added expense but also raises the denominator of the fixed charge coverage ratio that may be needed as part of a banking covenant.

Getting Caught in the Eye of the Storm: Debt to Earnings

Increased financing costs demands more cash from the business, not only to pay the interest expense but a multiplier more according to the banking covenant agreement to assure the bank of the manufacturer’s solvency. For example, if the Fixed Charge Coverage Ratio is 1.2, then the business must also generate earnings 20% more than just the increased interest expense. Conventional banking relationships usually prefer a Debt to Earnings ratio of three or less. If a manufacturer is operating with earnings less than a third or fourth of debt and a covenant is tripped, then getting caught with cash tied up in inventory puts that manufacturer in the crosshairs of the bank work-out group. Work-out might just lead to a more expensive banking relationship but a new focus on cash management, or it could be the beginning of the end for a business.

Batten Down the Hatches

Avoiding a fate of work-out first and foremost requires a cash focus. This starts with building and maintaining a cash flow forecast to look ahead into accounts receivable, accounts payable, and expected payroll to see when cash is generated or used.

While easier said than done, stop over-stocking raw materials. This will require engaging in frank discussions with your customers regarding the need for visibility to demand, and agreements to either limit orders or guarantees to cover stocking programs, such as customer-owned inventory.  

Lowering inventory slowly by selling it off is critical and there are often two pushbacks on this. One counterargument often used is that the higher inventory levels are helping inflate the borrowing base by some percentage of its value. To that, we say 100% of a dollar in hand is worth more than 40% or 80% of one on the shelf, even if it might take 45-90 days to see it. The second caution is often selling from inventory reverses costs back onto the income statement and lowers profit. 

For income-statement-focused banking agreements, this may also trip a covenant. It needs to be managed, but again it is better to have the cash in hand than a profit on paper. We recommend visiting and revisiting pricing agreements to ensure that increases in material costs are being fully covered and opportunities for repricing under contracts are not missed.

Ultimately, the business must drive better earnings. Focusing on generating sufficient value-added revenue production DAILY with the given headcount that day will drive better financial results and greater earnings at the end of each month. To keep everyone on pace, set and attain a schedule with a target value-add goal enabled by eliminating waste and visual techniques.

Conclusion

The collision of these storm fronts of increased lead times, delayed demand, and rising interest rates can put a manufacturer in the eye of a storm that could capsize the business. With a cash management focus, the manufacturer can free up cash on the balance sheet. And, a daily value-added revenue per full-time equivalent goal, can ultimately drive better earnings to keep healthy banking relationships and survive the storm.