The Hidden Costs of Working with Large Enterprises

For any business, the lure of landing that major client – the “big fish” – is often overwhelming. People dream of the prestige, the robust invoices, the stability. But sometimes, there are hidden costs that means a new opportunity isn’t always so golden.

Using a hypothetical example, let’s explore why this is the case.

Is Landing a Big Client Always a Good Thing?

Imagine this: As a mid-sized business owner, your company is performing well. Every month, you generate $500,000 in revenue, leading to a gross profit of $200,000 – a healthy 40% gross profit margin. Subtracting overheads leaves you with a net monthly profit of $100,000, equating to a tidy 20% net profit margin.

Now, consider a typical scenario: Your working capital – debtors, creditors, and stock – stands at $1.4 million, yielding a working capital percentage of 23.33%. As long as your gross profit percentage exceeds your working capital percentage, your business will generate more cash as it grows. At present, your business enjoys a 16.66% surplus – a commendable position, which allows a return on working capital of 85.7%.

Suddenly, the dream comes true – a large enterprise wants to do business with you, promising to boost your revenue by 50%. On the surface, it seems like a chance of a lifetime. But beneath the initial glow lies a more complicated truth.

The big client, let’s say a large tech company or supermarket, demands lower prices. So, your gross profit drops to 30%. This new business adds $250,000 in revenue, of which $75,000 is gross profit. Keeping overheads constant, your monthly profitability stands at $25,000 – just 10% net profit margin on the extra revenue. At first glance, this doesn’t look too troubling. After all, the net profit has grown by 25%.

However, there’s a catch: The big client has boosted your revenue by 50% but only increased your profit by 25%. This asymmetry is the first sign of trouble.

Next, let’s consider the impact on your cash flow and working capital. The big client doesn’t want to pay in 30 days. They insist on 90 days. Also, to avoid stock shortages, you need to hold six months’ worth of stock. This change increases your working capital needs significantly – debtor days average 50, while stock days rise to 142. Suddenly, your working capital swells to $3,025,000, pushing your working capital percentage to 33%.

Your once positive gap between gross profit and working capital percentage shrinks to a meagre 3%. Your return on working capital plummets to 54%. While this isn’t disastrous, it is a significant drop from your previous position.

By increasing your profitability by $25,000 a month, your working capital has surged by over $1 million. This additional capital has to come from somewhere – either directly from the business or from a loan, which you’d likely need to secure against your personal assets.

So, what started as an exciting opportunity has placed considerable strain on your cash flow, squeezed your profit margins, and increased your financial risk. Yes, your profit figure has increased, but the qualitative aspects of your business have taken a hit, as has your cash availability.

Conclusion

The take-home message is not that you should shun large enterprises. Instead, it’s crucial to approach these opportunities with caution. Assess the financial impact and ensure you fully understand how their requirements will affect your business. It’s about striking a balance – navigating the trade-offs between profitability, cash flow, and risk.