The Hidden Cash Allocation Mistake That Is a Sure Fire Way Out of Business

Business is all about making cash, reinvesting it to make more future cash flow, getting more cash, and repeating this cycle. That’s why maximizing your cash flow is super important. If you don’t, you’ll have less cash to allocate, limiting your future cash flow. Some companies get stuck in a nasty cash flow cycle: they allocate less cash to the right things, then get less future cash flow, allocate even less cash, get even less future cash flow… and before they know it, they’re dead in the water.

You might think this trap is easy to avoid, but it’s actually really tough. Why? Because of psychology.

Let’s look at a real-life example: Kmart, the US supermarket chain. Once upon a time, Kmart was bigger than Walmart. But it went bankrupt. Twice. Both times for the same reason: psychological consistency tendency.

Kmart’s First Fall: The Danger of Getting Too Comfortable

Kmart’s first bankruptcy was in 2002. Walmart and Target basically killed it. Here’s what happened:

  1. Kmart used to have no real competition. They didn’t have to reinvest their cash.
  2. They let their equipment and stores get old and shabby. People still came because they had no choice.
  3. It was like a marriage where you stop trying to look good because you think your spouse won’t leave.

But when rivals showed up, Kmart didn’t change. They thought, “Why change our strategy? It’s always worked before.”

Suddenly, people had choices. They could ditch the dingy Kmart and shop at shiny new Walmart low price stores. That was the beginning of the end for Kmart.

Kmart’s Second Stumble: When Money Games Trump Real Business

After the first bankruptcy, a rich hedge fund guy bought Kmart. But here’s the problem: he saw everything as a money game. Because that’s how he got rich before Kmart. Breaking old habits is super hard.

So what did he do? He played money games instead of fixing the actual stores. For example:

  1. He spent tons of cash buying back Kmart’s own stock.
  2. Meanwhile, Walmart was reinvesting in its stores, making them more attractive to customers.

Buying back stock is about increasing each investor’s slice of the pie by making fewer slices. But here’s the thing: if the whole pie (the company) dies, it doesn’t matter if you have a bigger slice or not. Zero is still zero.

The big mistake? Putting money games before better operations. Those financial tricks should be the last thing you do, not the first. You need to secure enough reinvestment in your business first. If there’s money left over, then you can play money games. Or you can borrow cash if it is a really rare lucky opportunity.

The Numbers Don’t Lie: Kmart’s Underinvestment

Let’s look at some real numbers to see how bad it was:

  1. In 2012, Kmart only invested $380 million in new property and equipment.
  2. But their depreciation cost (how much value their stuff lost that year) was $830 million.
  3. This means Kmart wasn’t even keeping up with how fast their stores and equipment were wearing out, let alone improving.

Compare that to Walmart:

  1. Walmart’s depreciation cost was $8.5 billion.
  2. But they spent $12.9 billion on new stores and equipment.
  3. Walmart was actually improving and expanding, not just treading water.

The Cash Flow Crunch: When Bad Decisions Snowball

Kmart’s problems weren’t just about not reinvesting. They also had terrible cash flow from their operations. This is the lifeblood of any business – the cash you make from actually selling stuff.

Why was Kmart’s cash flow so bad? A big reason was their high selling, general, and administrative (SGA) costs. The main part of SGA? Salaries. If you have too many employees for your sales, your SGA-to-sales ratio goes through the roof.

In 2012:

  • Kmart’s SGA-to-sales rate was a whopping 30%.
  • Walmart’s? Just 19%.

When profit margins in supermarkets are usually less than 5%, an 11% gap in costs is huge!

You can see this in their sales per employee:

  • Kmart: $145,000 per employee
  • Walmart: $213,000 per employee

Kmart was not selling well for the amount of employee.

The Final Straw: Empty Shelves and Dusty Inventory

Kmart’s sales were terrible. Why?

  1. Their stores were old and unappealing.
  2. Their prices weren’t competitive with Walmart or Target.
  3. Their product selection was awful.

People constantly complained about Kmart’s empty shelves. But here’s the kicker: their Days Inventory Outstanding (DIO) – how long it takes to sell their stock – was super long. This means Kmart was terrible at predicting what would sell.

The result? They bought too much of stuff nobody wanted and not enough of the popular items. It’s like a restaurant that’s always out of the good dishes but has plenty of the gross ones nobody orders.