Merrifield Consulting Group

July 3, 2022






            The severe national recession of 1981-82 and the localized rolling depressions for different industries and regions of the U. S. during the 80's have all been overshadowed by the 7 (+) years of U. S. economic expansion begun in 1982 on - the longest peacetime expansion ever.  Have most distribution firms been reflecting this prosperity in their financial statements? - No!


            1.         Sales are up for most equal to the growth in GNP, their respective industries and inflation, but profits have been flat and for many eroding.  According to Robert Morris statistics for 1986, over 48% of all Wholesale firms reported zero or negative earnings.  Another intermediary industry, Car Dealers, had 50% reporting losses for 1989.


                        Lesson:             Growing volume now has nothing to do with growing profits; it seems it may in many cases erode profits.  Sears and General Motors are two, number-one-market share giants that illustrate this point.


            2.         How do you finance growing inventory and receivables to support growing sales if retained earnings are flat or eroding? - You borrow more. During the 80's the average wholesaler has seen debt as a percent of capital in the business steadily rise.


                        Lesson:             Don't grow sales faster than retained earnings; otherwise debt will grow even faster until it becomes a problem.


            3.         Borrowing money is fine if you earn a greater pre-tax return on total assets than the interest rate cost; this is called positive leverage.  By example: if a firm has $5 million in total assets of which $1,000,000 is borrowed at prime plus 1% for all of 1989; and if the profit before interest and taxes (PBIT) of this firm is $500,000 on sales of $12,000,000 for 1989, then:


                                    PBIT                  =          500,000 =          10% Pre-Tax Return on

                                    Total Assets                   5,000,000                      Total Assets ("ROTA")


                        This clever business has borrowed 1,000,000 at 11.5% (prime average 10.5% in 1989) to put it into an asset investment pool of $5,000,000 to make 10% on it.  The 10% goes back to the bank plus another $10,500 to pay the full 11.5%.  The $10,500 comes out of the investors return.


                        Lesson:             Achieve "positive leverage" or pay-off debt.  Better to borrow at 11% to invest in something making 12% or more in order to boost investors' return.


            4.         Interest costs have never been at a higher after-tax, after-inflation cost than right now.  In 1981 the prime hit 21%, but most state (10%) and federal (46%) tax rates were 56% combined, and inflation was 13%.  Now, federal taxes are down from 46% to 34%, so assume state and federal add to 44%, and inflation is 4%.  If a private firm converts to sub-chapter S status, the max-tax becomes 28%!  Compare costs:






                                                                                    1981                 1989                 1989(Sub-S)


                        Borrowing Rate (Prime +1)                       22                     11.5                  11.5


                        After Taxes                                x          .46                    .56                    .72

                                                                                    10.12                6.44                  8.28


                        -Inflation                                               -13.0                 -4.00                 -4.00


                        Net Cost of Money                                   (2.88)               +2.44                +4.28


                        Lesson:             It appears that paying down expensive debt is the best thing, especially for Sub-S firms with a pre-tax ROTA of less than 12%.


            As the 80's end with the average firm showing a declining after-tax, after-inflation return on shareholder's investment (a.k.a. equity and net worth); and if the 90's promise high - real interest rates, slow growth, excess supply of goods; and too many volume-driven firms, we had better change our way of thinking and growing.  Some guidelines which I will address in future articles are:


            1.         Grow profits not volume; they aren't related anymore.


            2.         Determine what the "kinetic-chain" of profit causing factors are and address those to grow profits.


            3.         Focus less on buying low and selling products for a price (product-driven) and more on creating one-stop-shopping for all goods and services for some well defined customer segment; be customer needs driven.


            4.         Be a lender not a borrower during high, real interest cost, dis-inflationary times, unless your ROTA is consistently higher than borrowing costs.  Borrowers lost from 1950 to 1981, now they are winning.


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