LAS VEGAS—It's not what any business owner wants to hear: It is possible for a profitable firm to go bankrupt.
Norm Gaither of Virginia Beach, Va.-based The Gaither Group delivered that message at the recent International Tire Expo/Specialty Equipment Market Association show in Las Vegas. A consultant specializing in business profitability, Mr. Gaither presented a seminar called "Bankruptcy—The Danger Signs and How to Avoid Them."
Bankruptcy is a "scary word," he said, "but there can be a light at the end of the tunnel."
He cited a case several years ago where one of his clients was forced to sell his company because he had failed to understand the difference between mark-up and gross profit. Bankruptcy became a reality for this client even though his business had reported annual sales of $12 million.
"If you're not making the right profit, this is what can happen to you," Mr. Gaither said.
He explained two types of bankruptcy classifications for businesses—Chapter 7 and Chapter 11.
Chapter 7 proceedings occur when a business owner is out of cash and has no hope of turning the enterprise around, leaving the courts to appoint a trustee who sells all the assets.
The trustee then is responsible for paying all taxes and secured and unsecured lenders, Mr. Gaither said. Whatever is leftover goes to stockholders, although there is rarely any money left for them after the creditors are paid, he said.
Unlike Chapter 7, Mr. Gaither said Chapter 11 reorganization allows a business some breathing room to repay creditors. Business owners can pay their taxes over a period of time as long as they can show the government they are able to do that.
Under Chapter 11, unsecured creditors usually receive 25 to 30 percent of what's due to them.
There are, Mr. Gaither noted, 10 signs of potential bankruptcy that a business owner must heed:
Negative bank balances;
An inability to borrow from a bank;
An inability to pay current taxes;
Not enough investment;
Too much involvement from unproductive family members;
Not getting financial statements on time;
A payroll that's not in line with gross profit;
The owner's salary is too high;
The owner is never at work and loses track of workers; and
Liabilities are exceeding assets.
To avoid bankruptcy, Mr. Gaither said, an entrepreneur must sit down with an accountant and calculate the company's liabilities vs. how much cash it expects to take in. A business should be able to keep at least 5 percent of its sales after taxes as profit.
"Anything less means you're struggling," he said.
A company's budget shouldn't stay the same every year, and should make allowances for competitors, he added. For example, one of his clients who earned a 39-percent gross profit on annual sales of $2.5 million one year changed nothing in his budget the next year, only to see an aggressive competitor take away some of his sales.
Then the client decided to match the competitor dollar for dollar in price offerings, giving up a percentage of his gross profit to make up for lower sales. He also adjusted his budget for a 5-percent employee pay raise. The client's gross profit dropped 1 percent the following year, and his net profit became a loss, Mr. Gaither said.
The client again tried to match his competitor's prices the next year with discounts, lost another 1 percent of his gross profit in the process but still gave his workers a 5-percent raise, causing a net loss that year of 4.5 percent.
Mr. Gaither said he told the business owner that he had overpaid the employees and needed to cut his sales back. "It's not about getting more sales," he said. "That's what gave you a problem in the first place."
Another of Mr. Gaither's clients was a tire dealer with eight stores. He had acquired four underperforming stores with the intent of turning them around—but lost $200,000 in sales after the purchase.
"We literally did this—we raised prices, fired those (employees) who were underproducing and hired new ones," Mr. Gaither said, referring to the actions he advised the dealer to take. "We raised the gross profit, closed one store that couldn't be fixed, and now the guy expects to make a $450,000 profit this year."
Mr. Gaither emphasized that the single biggest cause of bankruptcy is too much payroll. If business owners want to make a good net profit, he advised they should earmark no more than 45 percent of gross profit towards payroll.
"Most businesses that aren't aware of this rule are usually at 60 percent and are probably close to breaking even or losing money," he said. "It doesn't take 60 percent to run a business. If it does, you're mismanaging your business."
Instead of raising salaries, Mr. Gaither encourages business owners to adopt a monthly incentive plan allowing employees to earn bonuses if they exceed monthly sales goals.
Above all, he said, bankruptcy can be avoided if owners—and their accountants—monitor cash flow and anticipate unexpected expenses.