what does free cash flow

8/7/2019 What Does Free Cash Flow

1/22

What Does Free Cash Flow - FCFMean?

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF)represents the cash that a company is able to generate after laying out the money required to maintain or expand its assetbase. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:

It can also be calculated by taking operating cash flow and subtracting capital expenditures.Investopedia explains Free Cash Flow - FCF

some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earningscan often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believethat FCF gives a much clearer view of the ability to generate cash (and thus profits).It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that acompany is making large investments. If these investments earn a high return, the strategy has the potential to pay off inthe long run.

Chapter 6: Working Capital ManagementWorking Capital is the money used to make goods and attract sales. The less Working Capitalused to attract sales, the higher is likely to be the return on investment. Working Capitalmanagement is about the commercial and financial aspects of Inventory, credit, purchasing,marketing, and royalty and investment policy. The higher the profit margin, the lower is likely tobe the level of Working Capital tied up in creating and selling titles. The faster that we create andsell the books the higher is likely to be the return on investment. Thus when we have been usingthe word investment in the chapter on pricing, we have been discussing Working Capital.

In the earlier chapter on Accounting concepts we showed a sample Balance Sheet. The Balance

Sheet comprises Long term Assets (real estate, motor vehicles, machinery) and Net CurrentAssets. The word Working Capital is often used for Net Current Assets. In this chapter we willexclude Cash in Bank from our definition. Thus our Balance Sheet appears as follows:

Long Term Assets 6,000Working Capital 28,000Cash in Bank 1,000

Total Capital 35,000

We defined Net Current Assets as Total Current Assets less Total Current Liabilities. In this bookwe shall subtract current liabilities items from current assets as follows:

Young

Inventory 15,000

Receivables 17,000

Prepayments 6,000

Payables (9,000)

Customer Prepayments (1,000)

Working Capital 28,000

Using this format we can state than any reduction in the Working Capital figure, other than forprovisions for write-offs and write-downs, will generate the same amount of cash. Thus if a


2/22

customer pays US$ 500 that he owes to the organisation, the Working Capital figure will fall beUS$ 500, and the cash figure will be increased by the same figure. This revised format is usefulwhen designing spreadsheet financial planning models for business plans or for internal reporting.

The Working Capital cycle, or Cash Conversion cycle as it is also called is usually expressed interms of the number of days. This figure is the average time that it takes to turn investment inbooks into cash and profit. We studied Payback in the previous chapter. Payback expresses thenumber of days required to recoup the original investment on a single title. In the organisations

Balance Sheet there will be the costs of paper, titles still under development, author advances ofbooks already and not yet published. In addition there will be the cost of stocks of unsold books,Accounts Receivable, and Accounts Payable.Example: Osiris publishers

In order to illustrate the concept I have adapted slightly the example used in the chapter onAccounting concepts. The Young scenario has the same Income Statement but I have adaptedthe Prepayments figure within the Balance Sheet in order to illustrate more elements of

Working Capital. I have divided the Prepayments figure of 6,000 into Prepayments to authors andPrepayments to printers. The totals are the same.

Income Statement Osiris

Turnover 100,000

Cost of Sales (57,000)

Royalties (18,000)

Gross Profit 25,000

Distribution costs (5,000)

Promotion (2,000)

Write-offs (3,000)

Administration costs (10,000)

Operating Profit 5,000

Analysis

Balance Sheet Osiris Working Capital /Sales %

28.00%

Inventory 15,000 Inventory in days 96

Receivables 17,000 Receivables in days 62

Prepayments: authors 3,000 Prepayments indays: authors

61

Prepayments : printers 3,000 Prepayments indays : printers

19

Payables (9,000) Payables (36)

Customer Prepayments (1,000) CustomerPrepayments

(4)

Working Capital 28,000 Working CapitalCycle in days

198

Explanation of the calculations


3/22

Working Capitalfigure

Explanation

Inventory in days (Inventory / Cost of Sales) x 365 = 96 days.More correctly the purchases figure, if availableshould be used, in this case excluding royalties.

Thus the publisher holds approximately 2

months of unsold inventoryAccounts receivable indays

(Receivables / Turnover) x 365 = 62 days.Assuming the turnover is phased evenlythroughout the year, this means the onaverage customers take 62 days to pay

Prepayments in days authors

(Prepayment: authors / Royalties) x 365 = 61days. In practice royalties will be earned thatreduce this figure while new advances are alsopaid to other authors.

Prepayments in days printers

(Prepayment: printers / Cost of sales) x 365 =19 days. In practice part of the Cost of Salesfigure would be new title pre-press costs notcarried out at the printer. This item relates to

cases where advance payments are made toprinters as a deposit or for paper. Thepurchases figure if available would give a moreaccurate figure.

Accounts Payable indays

(Payables /(All purchases) x 365

(9,000 / (57,000 + 18,000 + 5,000 + 2,000 +10,000) x 365 = 36 days

The purchases (investment) rather than thecost of sales figure should be used if available. Ihave assumed that this figure includes moneyowed to authors (see prepayment: authors)

CustomerPrepayments

(Customer Prepayments / Turnover) * 365 = 4days

Working Capital cyclein days

96 + 62 + 61 + 19 - 36 - 4 = 198

Working Capital / Sales%

28,000 / 100,000 = 28%

Explanation of the figures

On average it takes Osiris 198 days to turn an investment into cash and profit.

New tiles will use more Working Capital than reprints On average Working Capital equates to 28% of turnover

The percentage of Working Capital to turnover varies according to the type of publishing

Trade publishing in developed countries may have a figure of between 35- 45 % ofturnover. Academic publishing is higher. Professional publishing uses a lower WorkingCapital % figure

Working Capital is also a measure of risk

This figure may include new titles, reprints, foreign language coeditions, licence sales. The figurewould be different for each of these. Within the total Balance Sheet, the Working Capital figure


4/22

will vary throughout the year according to the phasing of new titles and the sales cycle.Publishers should know the typical Working Capital cycle and the level of Working Capital as a %of turnover for each market or distributor, for each category of book.

The relevance of Working Capital to publishing in young economies

In the FSU Working Capital levels were controlled at government rather than factory level.Invoices were settled on standard credit terms. Non or slow payment was not a major problem forprinters and publishers. Risk was a government problem. Authors were paid standard royaltyrates and terms. Inventory levels and print runs were according to a formula: in textbookpublishing, 150% of the textbook requirement would be printed in year 1, the remaining 50%would be used for replacement copies in subsequent years. Publishers, printers and distributorswould negotiate for annual cash budgets but did not have to concern themselves about WorkingCapital questions except where budget moneys were delayed.

Printing capacity was sufficient to produce local and other agreed requirements. Thus textbookprinting would commence in November for the following September. In a competitive openeconomy printers would have to offer discounts and credit to persuade publishers to take the riskof early ordering. Schools would demand the latest up-to-date editions. Publishers would have toborrow money from the bank or shareholders to pay for the inventory.

For young economies, the implications are as follows.

1. In young economies the first industries to develop are those with low or negative WorkingCapital % to sales. Negative Working Capital is where the organisation uses supplier creditor customer Prepayments to fund their day to day needs.E.G. banks and financial services, retailers, distribution, industries with cash sales oradvance payments on signature of contract (e.g. printers). Organisations with negativeWorking Capital use the money from their customers with which to invest and to paysuppliers.

2. Competition is fiercest among industries with low or negative Working Capital / sales %figures. Financial entry barriers are lower and these industries are easier to expand.

However profit margins are often lower because of the competition (but not always!) andthe failure rate among such industries among developed countries is usually higher.

3. Banks are attracted to industries with low or negative Working Capital / sales % figures ascash and profits are earned more quickly

4. Entrepreneurs are attracted to industries with low or negative Working Capital % figures5. Most marketing innovations in book publishing have come about through the application of

the above Working Capital concepts to creating additional sales and expanding themarket. Most of the innovations introduced at the end of the previous chapter werecreated by reduced the level of Working Capital and the time schedule of creating andselling books.

6. The customers, suppliers and authors of book publishers also want to operate to a low ornegative Working Capital / sales %. Thus printers ask for advance payments e.g. for paper,distributors will try to withhold payment until they have received money from their

customers.7. Printers are loath to change from their dominant position where they could dictate prices

and schedules according to price scales formulated at state level. These price scales weregeared to maximum production output, not to satisfying publishers and their customersunder national or international competition. 4-colour printing would cost 4-times the costof single colour printing, despite the introduction of modern 4-colour sheet-fed presses.Printers will change their attitude to pricing and print-runs only in a crisis. In many youngeconomies printers have not co-operated with publishers (partly the fault of thepublishers) and faced near collapse as publishers have purchased printing overseas.

8. In developed countries publishers have sometimes allowed retail groups extra credit (=higher Working Capital for publishers) in order to encourage them to expand into new


5/22

outlets or sell more books. It is essential to distinguish between genuine expansion casesand opportunistic entrepreneurs. The more a publisher is actively engaged in marketingand distribution, the less likely is the publisher to have to rely on offering credit as anincentive.

9. The concept applies equally to state enterprises and non-profit making organisations. Ifcash and profits are generated more quickly, new titles can be commissioned sooner, staffand suppliers paid promptly. Bank interest is reduced.

10. Where producers are dominant, their customers will have to accept higher levels of

Working Capital. Where customers are dominant, the producers have to accept a greaterburden. In some young economies, the government may have a policy of holding keyorganisations in the state sector or as majority owned state enterprises rather thanencouraging a free-for-all enterprise policy. This may affect printers, publishers anddistributors. This policy will affect the evolution of the Working Capital cycle and may tilt itmore in favour of producers.

Working Capital levels in book publishing in developed countries

Working Capital is a major problem in book publishing. Most publishers solve the question on atemporary basis by negotiating credit with printers and other suppliers. Their own customerssolve the problem by negotiating credit with publishers or demanding sale or return terms.

Sale or return terms make planning and cash forecasting much more difficult. Most publishersrightly prefer to offer a slightly higher discount for a firm sale. Retailers will argue that they wouldnot purchase many new titles without their risk being mitigated by a sale-or-return policy

The central issues, which must be solved, are:

Investment decisions rely too heavily on economies of scale e.g. in printing prices, byamortising first edition costs against larger print runs

Publishers produce too many titles, which receive too little promotional effort and thus sellslowly or not at all.

These can be solved only through long term changes in publishing strategy and greater attention

to the value chain where suppliers, publishers, wholesalers and retailers co-operate to mutualbenefit and shared risk. On demand publishing may reduce inventory levels but does not solve

the marketing aspects.

Many publishers have studied the publishing of music CDs and cassettes, and of greeting cardswith a view to finding solutions. While lessons can be learned, there are major differences:

CDs, cassettes and greeting cards

Are all high margin projects

Carry much heavier promotion budgets and commitment to marketing

Are standardised in format

Enjoy few economies of scale so short run and on-demand manufacture are the norm

Sell to a more wide variety of retailers

Sell on a less seasonal basis

Paperback publishers have adopted some of these aspects and have fought successfully toovercome the low price perception of paperbacks. Paperbacks can now sell in many cases at thesame price as a hardback edition. The creation of hit-parades or Top 10 listings has beenadopted for books of different categories and has attracted significant media attention thusmaking books more fashionable. As a result books may sell faster, perhaps at higher prices andthus reduce Working Capital levels.


6/22


7/22

The Working Capital cycle in both cases is similar in both cases. The reason is perhaps the same.Neither the book packager nor the young private publisher is adequately financed; both enjoy thecreative aspects but do not want to expand if it means losing control. There are few potentialbuyers for book packagers.

The cost of starting such organisations is much lower. Working Capital is lower because they areinvolved only in creating the books. They influence distributors, retailers and consumers only solong as they generate saleable new ideas. While book packagers can of course sell foreign rights,

their potential to sell reprints is lower.

Making more efficient use of Working Capital

The table below lists items, which influence Working Capital levels favourably and adversely

Items that reduce WorkingCapital levels for publishers

Items that increase WorkingCapital levels for publishers

- Increased profit margins - Lower profit margins

- Customers who pay promptly- Advance payments by customers

- Long print runs except where allthe books are required onpublication e.g. School anduniversity textbooks

- Inventory which is sold and paidfor quickly by customers afterpublication- Lower Inventory levels byreducing print quantities andworking with printers who willdeliver quickly and produce lowprint runs economically

- Slow authors who deliver lateand whose manuscripts requiresubstantial editing- Holding paper stock unlessmarket conditions demand andthe savings are large- Slow schedules for thedevelopment of new titles

- Successful promotion that speedsup the rate of sale

- Making advance payments toprinters- Seasonal sales except where thepublishers prints only for theseason

- Licensing (but problematic inyoung economies)

- Paying suppliers on completionwith credit- Authors who deliver manuscriptson disk ready for computer make-up- Incentives to staff , authors ,suppliers, customers , sales staffand agents to speed up the rate ofsale and of developing new books,delivering manuscripts onschedule

The attention of readers is again drawn to the examples at the end of the previous chapter, whichillustrate ways in which publishers have produced affordable books through a marketing initiative.

The concepts of this chapter apply in each example.


8/22

The danger of averaging Working Capital levels

Osiris has a Working Capital to Sales figure of 28%. However the figure will be the average of theorganisations different activities. Let us assume that there are three divisions that producedifferent types of books for different markets and use different methods of distribution. The tablebelow shows how each division generates much Net Contribution and also how much WorkingCapital is used in each division. The cost of sales, royalty, distribution, promotion costs and write-

off figures differ in each case as a percentage of sales although not all the costs are necessarilyvariable. The term Net Contribution is the amount of money that each division generates towardsthe central administration cost of the company and hence to profit. Items below Net Contributionis not relevant to our analysis unless administration cost vary according to each market. Intereston bank loans could however be usefully charged against each division to give an even moremeaningful figure. Although a Balance Sheet item, Working Capital is shown under NetContribution to highlight the relevance of comparing Net Contribution and Working Capital levelsby division.

Income Statement Division A Division B Division C Total

Turnover 60,000 30,000 10,000 100,000Cost of Sales (33,000) (18,000) (6,000) (57,000)

Royalties (10,800) (6,200) (1,000) (18,000)

Gross Profit 16,200 5,800 3,000 25,000

Distribution costs (3,900) (1,000) (100) (5,000)

Promotion (1,100) (900) 0 (2,000)

Write-offs (1,700) (1,100) (200) (3,000)

Net Contribution** 9,500 2,800 2,700 15,000

Working Capital 19,200 7,800 1,000 28,000

** Gross Profit less distribution, promotion and write-offs. The contribution to administration costs

and profit from publishing activities

The analysis of the above sheds useful light on profitability and use of Working Capital by division.This is discussed in detail below.

Analysis of the net contribution

The table below shows each cost item included in the Net Contribution calculation expressed as apercentage of turnover.

DivisionA

DivisionB

DivisionC

Average

Cost of Sales % to Turnover 55.0% 60.0% 60.0% 57.0%

Royalty % to turnover 18.0% 20.7% 10.0% 18.0%

Gross profit margin % 27.0% 19.3% 30.0% 25.0%

Distribution % to turnover 6.5% 3.3% 1.0% 5.0%

Promotion % to turnover 1.8% 3.0% 0.0% 2.0%

Write-off % to turnover 2.8% 3.7% 2.0% 3.0%


9/22

Net Contribution % toturnover

15.8% 9.3% 27.0% 15.0%

Working Capital / Turnover%

32.0% 26.0% 10.0% 28.0%

Turnover

The turnover figure is the sum of the sales invoices issued during the year by division. Any returnsor invoice queries would be shown separately under write-offs in order to highlight tomanagement the extent of returns and invoices queries. The company will invoice either bycharging an agreed discount off the recommended retail price, or by using an agreed unit price. Iftransport is included in the invoice price, the charge for transport will be shown as an expenseunder distribution. Free samples or extra jackets may also be included in the invoice price.

Cost of sales

The percentage to turnover is influenced by the sales mix, the balance of new and reprint titles,and the length of print runs. A larger print run might increase the gross margin % but alsoincrease Working Capital levels and hence reduce the cash in bank figure.

Some organisations will charge new title costs in different percentages to each market. The aim isto demonstrate that certain markets are profitable, but only on a marginal costing basis. If anorganisation has to increase prices to local bookshops as a result of charging all new title costsagainst the home market, the organisation runs the risk of losing market share and profitability inthe home bookshop market

Other publishers, often the more progressive, may therefore regard new title costs as researchand development, and charge e.g. 1/12th each month following publication against the IncomeStatement. This policy means that inventory is valued at a cost excluding new title costs andreduces the need for write-offs. This policy also gives a better view of trends in gross margins, asthe figure is not distorted by changes in the new title / reprint mix. The Net Income will fall.Countries may have specific policies for writing off first edition costs against profits, as they aresimilar in concept to research and development expenditure.

Royalty figures

The royalty figures differ because in the case of division A and B, the royalty is charged on thebasis of the retail price, while in the case of division C, the royalty payable is based on netreceipts, i.e. the unit price charged net of discounts. As markets expand, the need to negotiateroyalty terms based on net receipts will grow in order that publishers exploit new markets.Without such author contractual terms, publishers might have to reject otherwise profitable deals.

Thus the author might lose also. It is common for net receipts royalty rates to be agreed for dealsabove a certain discount rate, e.g. bookclub, export deals, coeditions, and licences.

Gross margin

Definition: Turnover minus cost of sales and royalties payable.

Gross margin, the percentage of gross profit to turnover is widely used in book publishing as aparameter for book pricing. Where an organisation produces books with a similar cost profile, insimilar print runs, and with a constant sales mix, gross profit may be a useful criterion. Here thefigures highlight also that the use of gross margin as a criterion is not always useful and can bemisleading although the division C, with the highest gross margin, also has the highest netcontribution. Use of gross margin ignores distribution, promotion and write-offs, which will usuallydiffer by division or type of book.


10/22

Distribution costsDistribution costs will include the following:

Cost of own warehouse in handling the years sales

Cost of using someone elses warehouse for the same purpose

Using a contractor who handles your organisations distribution on a percentage of turnover basis forwarehousing, transport, packing, invoicing but not selling.

Transport and postage costs

Packing materials

Handling returned copies

Sales invoicing and credit collection (in some developed countries)The percentage cost will vary according to the method of market distribution used. If the books are sold to a distributorwho buys the books on a firm-sale basis and who will sell, warehouse and transport the books to customers, thendistribution costs will be low or nil. The publishers influence and control over the market will also however be low or zeroalso. In the case of a bookclub, the bookclub will demand delivery to their warehouse in bulk and distribution costs for thepublisher will thus be limited to transport costs to the bookclubs warehouse.Promotion costsThis includes the costs of promotion and selling whether carried out by the publishers or by other companies who carry outthe publishers instructions.The following will be included:

Publishers own sales force

Sales commission to agents who sales on a commission basis only or to sales staff who are paid partly by salary,partly on commission

Advertising agency costs

Some publishers may include samples under this headingWrite-offsWrite-offs are provisions against things that are likely to go wrong. The rule is that bad news has to be charged to theIncome Statement as soon as known whereas good news e.g. a large sales order for future delivery is not shown as a profituntil realisedThe following would be included

Doubtful debt provisions

Bad debts

Inventory that will not recover the cost of producing it

Sales invoice queries

Returned books (these are often shown separately as part of the turnover figures e.g.

Gross turnover 105,000Returns provision 5,000Sales turnover 100,000

Currency losses (or gains) on sales and purchase invoices

Royality advance write-offsNet ContributionDefinition: Gross profit minus distribution and promotion costs, and write-offs

The Net Contribution shows the contribution from publishing activities of each division or market. While the figure isimmensely useful, the percentage figure must be used with caution as both fixed and variable costs have been deductedfrom turnover.Licensing Income would also be shown, if significant, as a separate item and not necessarily as part of turnover. Whilelicensing can be risky in young countries, it is a significant part of publishing in developed countries where the legal

system or local publishing association will be active in protecting publishers rights. Showing licensing Income as part ofturnover has misled publishers for years over the value of rights income to profitability and to an acceptable return oncapital %.Net Contribution from Book Sales 15,000Licensing Income (net of royalties payable) say 500Total Net Contribution from publishing activities 15,500

Analysis of Working Capital levels by division

After a rather long diversion we now revert to Working Capital using the same example. The table below shows howefficient each division is in using Working Capital.


11/22

Division A Division B Division C Average

% Sales Turnover 60.0% 30.0% 10.0% 100.0%

% Net Contribution /total Netcontribution

63.3% 18.7% 18.0% 15.0%

% Working Capital 68.6% 27.9% 3.6% 100.0%

Net Contribution / Working Capital % 49.5% 35.9% 270.0% 53.6%

Net Contribution per 1 USD WorkingCapital

49.48 35.90 270.00 53.57

Explanation using division C as an exampleWhile generating only 10% of total turnover, but 18% of total Net Contribution, Division C uses only 3.6% of the totalWorking Capital tied up in the company. Division C makes US$ 2.70 Net Contribution for every 1 US$ of WorkingCapital used in Division C.For both entrepreneurs and for publishers unable to borrow more money from the bank or shareholders, the NetContribution per 1 US$ of Working Capital is vital. If we were to add the Working Capital cycle (198 days in the case ofOsiris earlier in the chapter) for each division, the report that we have just studied would be even more useful.

Growth opportunities

The following analysis of the same data shows the importance of Working Capital levels in generating cash as well as

profit. Using the above data we can extract the following

Impact of USD 1,000 increase in

sales volume

Division A Division B Division C Average

Increase in Contribution 158 93 270 150

Increase in Working Capital 320 260 100 280

For every additional US$ 1,000 of turnover, US$ 320 of Working Capital is required in Division A, US$ 260 in division B,and only US$ 100. It is rare that the division with the lowest Working Capital requirement will also have the highest netcontribution % but that is what division C offers. Division C might perhaps consist of reprints or foreign language editionsonly.

Calculating cashflow using Working Capital

We can project future cashflows using the Working Capital data. We are assuming that there are no additional purchases of

long term assets involved. Any other additional items of expenditure that are required to support the change would also beincluded e.g. an additional editor, a new personal computer.(a) using the Osiris average net contribution and Working Capital / turnover percentagesIn the first case we will calculate the future cashflows over a three-year period using the average net contributionpercentage and average Working Capital % for Osiris. It shows the impact on cashflows starting with sales of US$ 1,000 inthe first year.

Assumption

Turnover growth % 10% 10%

Net Contribution % 15% 15% 15%

Working Capital % to turnover 28% 28% 28%

Osiris Analysis xxxx1 xxxx2 xxxx3

Turnover 1,000 1,100 1,210

Net Contribution 150 165 182

Working Capital 280 308 339

Cashflow (130) 137 151

Bank figure (130) 7 158

As we are studying the cashflow on an incremental basis, the opening Working Capital figure, as for a new project, wouldbe zero. The calculation for cashflow in the first year is as follows:


12/22

Cashflow: year 1 = Net Profit Contribution** plus increase in Working Capital **= 150 +0 280 = (130)Cashflow: year 2 = 165 +280 308 = 137Cashflow: year 3 = 182 + 308 339 = 151** Plus any purchases of long term assets and additional administration expenses required as a result of the decision. Netprofit contribution is used instead of profit because we are studying the impact on cashflow of increasing sales turnover.Only incremental costs and sales are included.(b) using the net contribution and Working Capital / turnover percentages for Division C which has both the

highest net contribution % and the lowest Working Capital / turnover %

Assumption

Turnover growth % 10% 10%

Net Contribution % 27% 27% 27%

Working Capital % to turnover 10% 10% 10%

Division C Analysis xxxx1 xxxx2 xxxx3

Turnover 1,000 1,100 1,210

Net Contribution 270 297 327

Working Capital 100 110 121

Cashflow 170 287 316

Bank figure 170 457 773

Thus an expansion in Division C of USD 1,000 in turnover, and thereafter an increase of 10% per year cumulative,generates USD 773 of additional cash as compared with USD 158 in the average scenario for Osiris. The difference isexplained as follows:Increase in Bank figure: Osiris average 158Additional net contribution from division C 397Cash improvement due to lower Working Capital % in division C 218Closing Bank figure for division C : year 3 773Most of the increase in the bank position is the resulting of higher profits but the lower level of Working Capital in divisionC also results in an additional cashflow improvement of US$ 218.Notes on the Cashflow calculations

In practice we would add back to the net contribution figures that part of write-offs that was included for future problems.This is because such provisions do not affect cashflow.We can apply the same concepts for the preparing of spreadsheet-generated Business Plan forecasts. In such cases allIncome Statement and Balance Sheet items would be included. Cashflow can be forecast using the Balance Sheet ratherthan through a tale of Receipts and payments. The resulting cashflow figure will be the same under either method. Usingthe Balance Sheet figure above, different scenarios can be studied, as the spreadsheet model can be parameter driven.Thus changes in credit terms, inventory levels, margins can be studied quickly.Pareto's Law - the 80/20 ruleThis rule states that invariably time, sales, costs, or problem areas occupy a disproportionately high percentage of time ormoney. In publishing we might use the rule as follows:

80% of inventory held is for only 20% of the titles published

80% of our profits are made by 20% of the titles we publish

80% of our turnover is made from 20% of our customers

80% of our slow payments are caused by 20% of our customers 80% of our Working Capital relates to 20% of our list or 20% of sales turnover.

80% of out time is spent on 20% of our titlesThis general rule can be applied in so many ways to financial management in book publishing.

A detailed Look at the elements of Working CapitalInventoryInventory will consist of:

Un-printed paper

Flat printed sheets

New books and reprints under development


13/22

Finished Inventory

Publishing plant (discussed in chapters 4 and )Unprinted paper In young economies paper may represent 40-50% of the price of a book while in developed countries thepercentage may be 10 15% of the selling price. Thus in young economies, economic purchase of paper is a major issue.In some countries paper is a scarce commodity with prices at a premium.In developed countries publishers will uses several printers in different countries. The normal procedure for bookpublishers, except for publishers of standard format paperbacks is to negotiate prices with printers, which include an agreedpaper specification. Newspaper and magazine publishers, who print to a single format using reels will normally purchase

paper in order to secure the lowest possible prices and in order to guarantees supplies.Paper is a commodity, but, unlike most commodities, is not traded on commodities' exchanges across the world. Attemptsare being made to develop a Futures Market for pulp. As a result there is no market price for each paper grade. Largeusers will negotiate significant discounts on published price lists. but such data is not published. Only for newsprint is therean open discussion on prices. Countries with strong economies and currencies will negotiate the best prices, whilecountries with no local pulp industries will distort price levels by panic buying.Young ambitious economies will require increasing levels of paper, as education, packaging and advertising become highpriorities. Where a country has an indigenous pulp and papermaking industry, this increase in demand causes papershortages and leads to higher prices. Consumers become more demanding and require higher quality papers, which are notavailable locally. Controlled paper distribution means that local users may pay a higher price for local paper than theircounterparts in developed countries. Unless subject to special trade agreements or supported by their local governmentse.g. for credit risk, foreign pulp and paper mills may charge higher prices to young economies because of the credit riskand because they do not always represent a major market to the mills. Local distributors are unlikely to inform publishers

that world paper prices are falling. Local distributors will often seek to limit alternate sources of supply. There is thus oftena large difference between prices charged by local distributors and those charged by the foreign paper mills who areprepared to supply direct.Many publishers in young economies will not purchase paper through the printer for two key reasons. Printers will oftenmake a surcharge of up to 25% as well as demanding advance payment. In addition printers may give priority to customersprepared to pay higher prices for printing and paper and thus jeopardise printing schedules.Thus publishers in young economies face three problems:

Paying no more than market prices for paper (with guaranteed quality)

Guaranteeing supplies of paper and thus books. Printers may give priority to publishers with paper stocks.

Finding cash or loans to pay for the paperMuch of the comment on book inventory applies also to paper stocks. It is cheaper and less risky to hold an inventory ofpaper than of books.Flat printed sheets These are flat printed sheets, which can be bound as hardback, paperback or other editions at a later

date. By not binding immediately the publisher also delays the cost of binding but will usually have to pay the printer forstorage. Wastage rates are higher when the binding is not carried out as a single run.Many publishers of short run editions will print extra 4-colour covers for later printings. A further use is where 4-colourillustration sheets are printed for later over-printing in other languages.New books and reprints under development (Work-in-Progress or WIP)This represents all the costs of creating new titles and reprints up to the stage where the books ready for sale. Editorial anddesign salaries will be included. As competition among publishers increases, publishers are forced to create more addedvalue to manuscripts and this increases the amount of new title costs and also WIP levels.Faster schedules will reduce WIP levels. This can be achieved by better scheduling, use of in-house DTP and scanningequipment, offering incentives to authors (for supplying manuscript on disk) or to staff and supplier for shorter lead-times.One publishing survey indicated that those publishers who worked to short schedules also had the lowest levels oftypesetting corrections. Seeing the finished book on which they have worked motivates certainly many publishing staff.

Finished InventoryEntrepreneurs and bankers are not attracted to many types of publishingbecause of the high Inventory levels. In developed countries these are still high, but falling, forthe following reasons:

Profit margins in publishing are not high

Printers offer significant economies of scale for longer print runs. Publishers are persuadedto print too many copies for too long a sales period. Publishers believe that book pricesmust rise if they pay a higher unit cost for printing. Most publishers in the FSU also sharethis view


14/22

Publishers will not always look at the Cashflow and Balance Sheet implications whenmaking decisions on print runs

Publishers price books on the basis of a single printing

Publishers are optimists

Publishers do not invest heavily in promotion

Most publishing courses teach full-cost costing for the pricing of investment decisions

Book sales are highly seasonal

Production staff are chosen for their design and technical rather commercial skills. Thetrend in most industries is for professional buyers, not (printbuying) specialists in aparticular industry

In younger economies publishers face a different scenario. Publishers in developed economies willprint in several countries either for financial reasons or in order to print at a source close tocustomers e.g. North America; Asia for the Australasian markets.

Printers in young economies will seek to export printing to developed countries to earn hardcurrency In order to break into these markets they will quote low prices on short print-runs inorder to enter the market. However, their local publishers are often forced to operate to theprinters terms of trade and pay higher prices. In order not to lose sales by being out-of-stock,publishers may print excessively large print runs. In addition, the culture of printing for 3 or 5

years as was the norm in the FSU, prolongs these attitudes especially among state publishers.

The subject of inventory levels and optimum print runs is so central to book publishing that it isdiscussed in great detail in chapter 7

The following will assist in reducing inventory levels:

Ways of reducingInventory

Explanation

Closer co-operation with

partnership printers

Publishers co-operate closely with one or 2

printers; contract on an annual basis;forward plan together. A partnership butwith no final investment in the otherpartner.

Market Research andadvance selling

Pre-selling before books are printing allowspublishers to fix more exact print runs

Increased promotionalactivity promotion

Promotion and greater sales effort in lessobvious areas e.g. smaller towns, may costless than interest payments to banks

Use of series andstandard formats

The use of standard (or a small number of)formats means that capacity can be bookedwith printers, paper purchased in bulk. The

exact print quantities per title are fixed lateron a monthly basis.

This is used for standard format paperbacks.This policy is as much about purchasingpolicy as printing machinery constraints.

Selling stock firm to anexclusive distributor

This was the procedure in the FSU. Todaymost of these state distributors havecollapsed or split up. Distributors willdemand large discounts for carrying the risk.


15/22

In many cases they will sell in the capital cityand large towns only. The distributor isneeded for expanding sales into smallertowns and rural areas. The use of more thana single channel of distribution encouragescompetition and improved sales

Sales Incentives,discounts

It may be appropriate to offer largerdiscounts or incentives to customers anddistributors

Printing contracts The negotiation of price schedules withequal emphasis on low make-ready costs

Accounts ReceivableObtaining money promptly from customers is a major problem inpublishing (and all industries) worldwide. Market leaders and dominant organisations will be paidmore promptly as their customers fear losing the profits that they earn from such sales.

In many countries over 10,000 new titles are published each year. Bookshops will sell severalthousand titles. The rate of sale of books is slow.

In order to encourage booksellers to stock titles credit is offered. With newspapers and magazinesthe product has a short shelf life but the cash cycle is short. In addition there are only a smallnumber of magazines or newspapers relative to the number of books published. Customers askfor their regular magazine or newspaper.

When selling to more distant customers e.g. in another country, credit is offered to take accountof the time required to transport and distribute the books.

In some countries the supplier has the statutory right to demand interest on overdue invoices.These schemes are in practice less useful than they appear as customers may use suppliers as abank.

Another key reason is that most customers in the book trade are under-financed. Rather thanraise additional share capital or bank loans, they use trade credit with their suppliers, thepublishers. This is partly because many customers may be privately owned but also because thelow return on capital from bookselling does not attract investment easily.

In order to encourage booksellers to buy new books, publishers will often offer to sell on a sale-or-return or sale and exchange basis.

Under sale-or-return basis the bookseller may send back stock not sold after an agreed number ofmonths. The bookseller must settle the invoice on the agreed date and will subtract returns fromsubsequent invoices. In the case of sale-or-exchange the bookseller may return unsold titles inexchange for purchasing the same number of similar new titles. This is used widely forpaperbacks and is particularly prevalent in North America for hardback editions also. The

Accounts Receivable figure must take account of the fact that the amount invoiced may exceedthe amount that will later be paid. This makes cashflow forecasting difficult. Most publishersprefer to agree larger discounts but sell firm.

Booksellers who pay late are in fact taking a larger discount. If the publisher earns a 25% Returnon Capital, or approximately 2% a month, the bookseller is thus taking an additional 2% discountfor every month that payment is delayed.

Incentives are frequently offered for prompt or early payment. Many customers will pay late andtake the discount, however!


16/22

The value of such discounts can be assessed either by using the IRR or NPV function on aspreadsheet or by the following formula:

The supplier offers credit terms of 30 days from delivery and acceptance. The supplier will accepta 2.5% discount of the invoice amount if the invoice is settled in 7 days.

The following ways of reducing Receivables are used in book publishing and other industries indeveloped countries

Method Comment

High Margin products If Retailers make a large profit from selling asuppliers goods, they may lose that profit ifthey do not pay on time

Market leadership As for high margin products

Credit checking beforethe contract isaccepted

This checks the credentials of the customer.Many Associations of Publishers operate acredit committee for their members. Banksoffer a credit reference service also

Frequent and promptdelivery

If customers know that they can obtain booksquickly and reliably, they can hold lower levelsof inventory. Many publishers focus on sellingbooks into rather than out of the bookshops

Formal methods ofpayment

Bank drafts, Bills of Exchange, Letters ofCredit, guarantees. Bonds

Retention ofownership

In some countries ownership does not pass tothe customer until the goods have been paidfor.

The accountsdepartment

Invariably the accounts department will beexpected to chase customer payments. Privatepublishers will give it high priority and ownerswill do it personally. It is quite different to mostfinancial accounting work and is a key priorityfor firms. Firm persuasion is needed rather

than accounting skills.Joint promotions,merchandising

These may expand the market and cost lessthan bank interest payments

Methods of paymentBanks, suppliers and their customers are forced to find more complexpayment methods in order to gain competitive advantage. These are needed to expand trade andto give confidence to encourage suppliers to enter into contracts. In order to stimulate credit


17/22

trade, banks created more formal payment methods. These are only as good as the financialstanding and reputation of each bank, supplier and customer.

The aims of these payments methods include the following:

To protect the supplier

To encourage the supplier to offer credit and more attractive prices

To convince the supplier that he will be paid once the customer has taken delivery To act as collateral to the supplier in particular to obtain bank overdrafts or lower rates of

interests

To reinforce the legal contract between supplier and customer

To encourage foreign trade; to obtain governmental credit insurance

In practice young publishers are more likely to encounter formal methods of payment whennegotiating with foreign printers.

Typical documents include the following:

Method ofPayment

Explanation

Bills ofExchange

Checks drawn on the customer by the supplier forpayment at a future date. The supplier will hand overdelivery and customs documents once the Bill ofExchange has been signed by the customer (for newcustomers) or perhaps immediately with trustedcustomers. The Bill may be deposited with thesuppliers bank and allow a lower rate of overdraftinterest. Alternatively Bills may be endorsed in orderto pay a supplier.

Bills normally assure prompt payment but do notguarantee payment

The use of Bills of Exchange must be agreed by bothparties during negotiations

Letters ofCredit

The customer signs these at contract stage. Thecustomer undertakes to pay in full provided certainlisted conditions are fulfilled. The conditions must becapable of clear non-subjective interpretation bycourts.

They are widely used in North America. In other parts

of the world they tend to be used for larger and longercontracts than Bills of Exchange. They are usuallyregarded as more reliable than Bills of Exchange.

Bankerschecks

A bank, after debiting the customers account, willissue a check to the supplier drawn on the same date.

The situation in young economies is quite different. Many of the items in the first table concerningthe collection of Receivables may not apply. Banks may not offer financial instruments such asBills of Exchange. Cash or deposits may be demanded wherever possible but distributors survive


18/22

on supplier credit. Often government departments will be slow payers. Publishers must thereforetake carefully researched risks and enter into alliances of mutual benefit.

Author royaltiesAuthors receive advances against future royalty earnings. They serve also topay the author while writing. In most cases they are non-returnable. Thus if sales are low or slowto emerge, the advance may be in excess of earned royalties and perhaps paid 2 years before thetotal sum is earned from sales. In developed countries, trade publishers and paperback publishers

will expect to write-off large amounts of unearned royalty advances each year. The payment ofhigh royalty advances, as publishers bid for market share, is cyclical. The advance will be againstearnings over the term of the contract which will be for several years and several printings andeditions.

In many types of publishing, the publisher will find an author who will be contracted to write to aspecification; Artists, photographers and photo agencies will be contracted to provide illustrationsand photographs. The publisher than provides more added value by the author. In such cases thelevel of advances and royalty rates will be lower. In other fields, e.g. academic publishing, authorsmay write for no or minimal advance as the incentive is to increase their academic reputation.

Publishers should regularly e.g. quarterly or twice a year, review those titles where advanceshave not been earned. Reprints may require the payment of no further royalties in cashflowterms.

In young economies the local Society of Authors may insist on standard royalty terms andadvances regardless of the type of book or print run. The terms appropriate to approvedtextbooks (print-run 100,000 plus) are quite different to those suitable for university publishing(print-run 500-2000) or to authors of original novels. Established authors benefit hugely but resistcompetition from new authors. Subject to the laws of the country and the availability of goodauthors, most countries will need to study variations on standard author contracts if authors,publishers distributors are to benefit from expanded book markets.

Computer programs exist for the monitoring and payment of author royalties. These are suitablefor publishers with large number of titles with complex contracts. However for most young

publishers a spreadsheet can be used to calculate the royalties earned, and payments due.

Prepayments to supplierIn developed economies publishers may buy coeditions for theexclusive licence to publish in a language from foreign publishers or book packagers. Packagersconcentrate on creating multi-language titles but sell the language rights to foreign and localpublishers; they do not involve themselves in the marketing or distribution of books. Typicalcontractual terms for packager and coedition contracts involve stage payments, on signature, onapproval for press and on delivery. Publishers who buy from coeditions or packager products canpublish smaller print runs more economically and without using their own editors. For rights deals,the publisher will purchase film and pay a royalty advance.

In FSU countries, many printers still demand payment in advance whereas in developed countries

60-90 days credit would be given to publishers. These are also Prepayments.

PayablesIn developed countries where printers compete aggressively on an international basis,credit of 30 - 120 days is used to encourage publishers. Private publishers will remain loyal to oneor more printers who offer substantial credit. This credit reduces Working Capital levels andreplaces loan capital in many cases. Private publishers will often negotiate lower printing pricesthan larger publishers will.


19/22

Customer payments in advanceCoeditions have already been discussed under Prepayments.Where publishers sell coeditions to foreign publishers they will receive advance payments whichwill be owed to their customers until the books are delivered and accepted.

Summary

In developed economies, companies are forced to find innovative ways of reducing WorkingCapital levels in order to maintain an acceptable Return on Capital Employed and in order tosurvive. In most cases those companies, which are most market, oriented and involved in marketdistribution e.g. retail groups will dictate terms to the producers. Where such compa-nies aresuccessful in expanding the market, the suppliers may benefit also.

EXAMPLE

In developed countries retailers of high priced items and items with slow stock turn, may refuse topurchase inventory and will accept only merchandising deals where the inventory belongs to thesupplier until the products are purchased by a consumer. The retailer is this acting as acommission sales agent only. The supplier is paid once the goods have been sold.

Investors, banks and suppliers support such companies provided that they are successful andexpanding. In many countries professional retailers are taking an increasing market share ofbookselling proving that bookselling is attractive to entrepreneurs. Booksellers compete againstother successful booksellers, against supermarkets, bookclubs. Printers, publishers, wholesalersand retailers operate in a value chain.

However in young economies there is little understanding of the value chain or teamwork.Printers, publishers, distributors and bookshops operate independently for survival. In the FSU,printers, publishers and distributors operated like watertight compartments with no overlap ofresponsibilities and reporting to different ministries. Working Capital was not a significant problemfor individual enterprises

Printers are accustomed to operating large factories and have to possess management,commercial and accounting skills. Their long-term assets may be used as collateral for loans. Atthe other end of the chain many state distributors have collapsed, as their vast inventoriesbecame unsaleable; many book retailers deserted bookselling to sell higher margin goods. Thepublisher is the least experienced business member of the chain: printers have business skills,distributors have a short Working Capital cycle and collect cash. Publishers Balance Sheets offerlittle potential for bank collateral. As a result publishers in young economies may feel initially at adisadvantage to their printers and distributors.

Working Capital characteristics of different types of publishing

Publisher Developed country Young economy

Schooltextbooks

Medium. High WIP but for asmall number of titles; lowbut seasonal Receivables;Author advances low;Payables average andseasonal

High WIP; Low Inventory ifbooks are successful;Receivables low andseasonal. Printeradvances high as printruns are often long.


20/22

However printers areattracted to the long runsand the guaranteedmarket and will start tooffer credit

Universitytextbooks

Medium. Similar to schooltextbooks; larger lists.Pricing competitive

High. Publishers will printfor several years.Receivables low as manybooks are sold for cash inuniversity bookshops.

Professionalbooks

Low. High WIP but smalllists; Receivables low asmany books are sold direct

High WIP and Inventory.Professional may pay ahigh price for importedbooks but not for localbooks

TradePublishers

High perhaps 35 40% ofturnover. Large inventorydue to need to sell to awide market and due to useof colour; High author

advances and Receivablescompensated by highPayables

Medium if books are soldto distributors onpublication: high WIP asmany titles; high authoradvances. Low

Receivables.

Academicpublishers

Very high. This is makingthe Internet and otherelectronic mediumattractive to Academicpublishers and theircustomers

Very high. Similarcharacteristics touniversity textbooks butWorking Capital levelshigher

Factors that reduce Working Capital levelsFrom the table above we can infer the followingchecklist of reducing Working Capital level in developed countries

Small numbers of titles

Need to buy rather than want to buy titles with unique information

Use of standard formats for paper printing and binding

Direct marketing

Closer involvement in market distribution

Publishing for clearly identifiable markets e.g. schools, doctors, accountants, lawyers

Short run printing

Book packaging

Titles where printing costs are a low % of the selling price

Whether the same list will apply to young economies will depend on average wages levels andother economic data such as the percentage of urban population to rural population. In developedcountries profitability for such publishers is linked to their ability to charge a premium price forneed-to-buy books. Computer books are a typical example: a typical PC will cost in excess ofUS$1,000. Thus the selling price of a book that assists the user to make better use of thecomputer and its software is linked to the benefit. In many young economies that may not yet bethe case.

The Value Chain - Supply and Marketing DecisionsThis chapter concludes by applying these


21/22

concepts to the Value Chain printers, publishers, distributors and retailers and concludes bystudying in detail the title investment decision.

Most market innovations have arisen through co-operation between suppliers in the Value Chain,and by the application of Return on Capital pricing. In general the supplier taking the greater riskwill be relieved of much of the Working Capital burden in order that the risk taker can invest inselling and promotion costs to enlarge the market.

Company Comment Implications for publisher

Printers Fixed costs are high.Profit Contribution % ishigh if labour is regardedas a fixed cost. WorkingCapital % of turnoverlow. (assumes thatpublishers suppliespaper). Printers nowcompete on an

international basis usingsimilar machinery. Manyreproduction prices havefallen by over 1000% inthe last 15 years.

Even if a printer adds only a10% profit margin, the returnon capital may be high. Fast

jobs are very profitable whenmeasured in terms of returnon Working Capital. Becauseof the large fixed costs,printers can vary prices ifthey need to attract more

work to fill their factories.Book printing is regarded asone of the more profitableparts of the printing industry

Distributor(who stores,transports andsells)

Profit Contribution %low. Working Capital as% of turnover also low.Payback period short.

Distributors will usuallyhave a very lowcapitalisation. If they do

not sell enough books,they cannot paypublishers or buy newstock

Distributors will concentrateon selling the more saleabletitles into the largest towns.

Therefore many titles arenever seen in many parts ofthe market unless theterritory is divided upbetween distributors.

CommissionSales Agents

Low profit per 1USD ofturnover but almost noWorking Capitalinvolved

Only one profit margin isadded as the publisher sellsdirectly to the retailer ratherthan to distributors. Thepublisher carries the totalWorking Capital burden.

Retailers Contribution % quitehigh, Working Capital %

of turnover medium ifthe shop is reasonablysuccessful.

The prices and profit marginon books are both low.

Bookclubs Low Receivables; highInventory; Very highentry costs beforebookclubs make a profitand generate cash.Advertising costs high

Bookclubs create andmaintain a customer base

Publishers Higher fixed costs as Publishers can sell direct to


22/22

own salesforce

salary costs have to bepaid but faster turnoverof inventory follows ifsales turnover increases

the larger shops in largetowns

Directmarketing

Higher fixed andvariable costs but, ifsuccessful, this is amplycompensated by theabsence of a discount todistributors of retailers

Higher contribution andreduced Working Capitallevels. Higher Break-evenpoint

Possible SolutionsIn financial terms there are three main choices:

To raise more finance in order to be able to take a longer term view of publishing

To develop innovative solutions involving the use of Working Capital to make books moreaffordable to more people and hence expand the market. This has to be linked to amarketing campaign carried out jointly with distributors, bookshops and other salesagents.

To change publishing policy and publish for different more attractive markets; developteamwork with partners who have common needs

It is interesting to note that many publishers in young economies have chosen to diversify intotrade book, often in colour and with long print runs, in order to pay for overheads. As the tableabove shows, trade publishing, based on the developed country model, usually has the highestlevel of Working Capital.

what does free cash flow

Documents