Dick Smith's smoke and mirrors

If you believe in magic, look away now as what I am about to say might be very disappointing. David Copperfield didn't make the Statue of Liberty disappear, Criss Angel can't levitate, and Dick Smith never made a profit in 2015.

The latter might not be too shocking given that Dick Smith is currently in administration, but thanks to the recent administrator's report from McGrathNicol we now know more about what actually went wrong.

So how does a company turn a $191m loss into a $72m profit? According to McGrathNicol, Dick Smith increasingly made its purchasing decisions based on maximizing rebates rather than focusing on what customers actually want.

These rebates reduced the cost of goods sold and marketing expenses — sometimes before anything was sold to customers — but they also led to a build-up of unwanted inventory. Unsurprisingly, Dick Smith's inventory turnover fell almost 17% to 3.6 times per year (for comparison JB Hi-Fi (ASX: JBH) turned its inventory over 6.1 times in 2015).

Dick Smith was also aggressive in its purchasing, exceeding its total purchasing budget for 2016 only four months into the financial year.

Inventory equals death

Inventory is a drain on cash because a company usually needs to pay its suppliers before it receives any cash from customers — and there's often a lengthy interim where stock is just sitting on the shelf. This is why retailers hold annual sales where they use discounting to sell as much old stock as possible.

Discounting reduces the profit margin but brings in cash, which can be used to purchase new ‘wanted' stock that can be sold at higher margins. Thanks to the focus on rebates, however, Dick Smith was stuck with a lot of stuff customers didn't want at any price.

In the final days, Dick Smith was desperate. It was unable to order new stock from ‘wanted brands' as suppliers placed the company on ‘stop supply' or ‘cash on delivery' — Apple was one of the brands doing the latter. Its final throw of the dice was a massive discounted sale across its stores, but this didn't generate enough cash to prolong its life and it eventually breached its debt covenants. The banks then pulled the plug.

Were there signs?

Dick Smith isn't the only company that has been caught out using rebates to boost profits. Target, owned by Wesfarmers (ASX:WES), also used this practice, which suggests that the activity might be more widespread than people think.

Unfortunately, spotting this red flag isn't easy — especially if your only focus is the income statement. But the rebate game does tend to show up in inventory turnover, which, if deteriorating, may be a sign that the company is finding it harder to sell its products. In Dick Smith's case, receivables turnover also rose sharply as suppliers refused to meet the rebate terms due to outstanding payments.

It's also a good idea to monitor cash flow, not just profits. As we explained in Top 5 financial ratios: Retailers, comparing free cash flow to profits can help show whether accounting ‘profit' is actually leading to cash in the bank. For Dick Smith, the operations didn't generate any excess cash in 2015 and instead lost $3.9m. Debt was used to cover its capital expenditure.

Dick Smith's actions will likely cast a shadow over the results of retailers this reporting season and we'll be watching closely to see if there are similar issues bubbling under the surface of other retailers.