The coupling of the dynamics of growth with that of net working capital (NWC) management creates recurring problems especially in reference to the context of small entrepreneurial firms. If considered on a strategic perspective, NWC management may be seen as a matter of assessing company's sustainable growth, given that pursuing too high a growth rate in the short term may prejudice liquidity as well as profitability over time and thus future growth.
The analysis of growth and stagnation of sales and financial crisis in a small firm operating in the pharmaceutical distribution industry in Southern Italy, provides an environment to study how the balancing of growth, liquidity and long term profitability becomes a puzzling task in the light of the bounded rationality of decision makers. In particular, in the case studied, the entrepreneur of a small firm increased its sales by extending terms of payment to customers and, consequently, expanding NWC. The growth of NWC generated liquidity needs that were satisfied by augmenting negative bank accounts. The increase of bank debts inflated interest costs thereby reducing operating cash flow. The decline of the operating cash flow, in turn, worsened the liquidity needs of the firm.
The lack of control over the NWC therefore generated the spiral increase in negative bank accounts increase in interest costs decrease in operating cash flow increase in liquidity needs increase in negative bank accounts. Misperception of feedback loops affecting sales revenues, NWC, cash flow and current income dynamics, as well as the role played by beliefs and rules of thumb rooted in the industry studied, explain why the entrepreneur responded to the contraction of income and cash flow by further increasing terms of payment thereupon worsening the company's financial crisis, which eventually evolved into an economic crisis too.
The paper illustrates how system dynamics models may help to understand why, due to the entrepreneur's mental model, apparently rational decisions generate counterintuitive and undesired consequences. By eliciting from the company's key-actors the way how they perceive each variable may differently affect other variables, dynamic modelling allows one to make mental models more explicit and fosters a deeper and better comprehension of dominant feedback loops and of trade-offs affecting NWC management.
1. The company's growth path in the years 1991-1995 and achieved operating results.
Licari & Sons Co. is a family-owned firm which operates - with nearly ten employees - in the medicines wholesale trade market, particularly in western Sicily. Such a market is characterized by a highly fragmented offer, due to the difficulties to build a sustainable competitive advantage which might lead to a significant customer loyalty. The past years have been characterized by a strong market stability, which has not only been caused by offer fragmentation, but also by reasonable profitability rates earned by competitors.
However, since the beginning of the '90s, the pharmaceutical sector has been characterized by deep changes, which have particularly concerned the come into force of new standard tariffs, which bounded the scope of medicines whose purchase is financed by the State.
|In a few years, such events and many other phenomena (e.g. concerning pu-blic authorizations|
|and tax rules), led to a crisis of many companies operating both in the production and in the wholesale and retail distribution stages. Particularly in western Sicily, many retailers have been shifting the burden on wholesalers; infact they have been often used to postpone payment of purchased goods also by far beyond negotiated terms. On the other hand, whole-|
salers' worry to lose significant market shares has caused a growing competition among them. In fact, terms of payment allowed to retailers have been increasing, even though terms of payment negotiated by wholesalers with industries have been decreasing. In a few years such phenomena have caused strong financial crises and a sharp profitability rates reduction in wholesale firms.
In spite of the above market trends, in the years 1991-1993 Licari & Sons Co. has pursued a market share increase strategy, through a progressive reduction of commercial mark-up (i.e. of average sales price) and an increase of terms of payment allowed to customers.
As a consequence of such a strategy, it is possible to observe that, particularly in the first three years, although sales revenues increased, a growing net working capital (i.e. accounts receivable plus inventories minus accounts payable) led to higher negative bank accounts and current financial costs, which caused a decreasing current income (fig. 1).
From the picture delineated, a number of puzzling questions flow: which mistakes have been made in the years 1991-1993? Which results could have been achieved if different commercial and financial policies should have been adopted? Which alternative policies could be adopted in the future in order to pursue a growth path that could be consistent with a proper "debts/equity" ratio, profitability and liquidity of the firm?
System Dynamics modelling may support entrepreneur to understand causes underlying the company's performance and to set proper policies in order to match growth with liquidity and profitability over time.
2. Feedback loops underlying the commercial policy.
Two main positive loops emerge from the analysis of the feedback structure which lies behind Licari & Sons' commercial policy. Such a policy hinges upon two commercial levers: terms of payment and mark-up . During the first two years, over the five which have been analysed, the
|Fig. 2: Positive feedback loops which can be initially fostered through aggressive commercial policies based on terms of payment increases and/or commercial mark-up decreases.||two positive loops generated a growth pattern which was initially compatible with a proper "debts/equity" ratio and with profitability and liquidity (fig. 2). The figure describes how both an increase in terms of payment and a decrease in commercial mark-up (and price) are likely to cause - after a delay - an increase in the number of customers and/or in average sales revenues per customer. If mark-up percentage decrease is offset by sales volumes increase, such aggressive commercial policies will give rise to|
higher sales revenues and to a first gross margin increase. Such an increase may allow - on a side - another price reduction (if sales volumes are expected to continue to grow) and - on another - may give rise to an increase in the current income. A current income increase will cause higher flows of funds and - net working capital being equal - higher net operational cash flows. Rules of thumb and routine decision-making explain why an increase in net operational cash flows might be transformed into a reduction of terms of payment allowed to customers. However, the positive feedback loops are counterbalanced by a number of negative feedback loops that generate limits to the growth of sales revenues (fig. 3). A first limit to growth can be found with regard to market variables and, particularly, to the stock of potential market and competitors' reactions to aggressive commercial policies pursued by the company. Another feedback loop is related to cus-
|Fig. 3: Limits to growth related to "aggressive" commercial policies only based on terms of payment increase and commercial mark-up reduction||tomer base dynamics. In fact, a growth policy aimed at improving the average number of customers is likely to increase the percentage of total sales to less solvent customer groups, which leads to higher credit collection delays. At the beginning, higher collection delays are usually tolerated by the company; nevertheless, whether they continue to grow, a customer base reduction|
policy is eventually needed. A customer selection policy is likely to give rise to a decrease in credit collection delays. The third negative feedback involves accounts receivable, NWC, net operational cash flow and terms of payment. As accounts receivable increase, net working capital increases too, which reduces net operational cash flow and eventually leads to lower terms of payment. In such a feedback, cash flow acts as a limit to terms of payment increase.
The case illustrates how entrepreneurial bias and misperception of feedback loops may evolve in a vicious positive loop. Negative cash flows have been a result of sales revenues and current income flows lower than the net working capital increase. Lack of liquidity gave rise to negative bank accounts which increased current interest costs, leading to a lower current income, which in turn evolved into lower cash flows. Such a "death spiral" could be interrupted, for example, either by increasing the company's equity or by increasing price (if demand is unelastic) or by decreasing terms of payment or even by a combination of the three policies.
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