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The Investment Lesson in Groupon Killing Small Businesses

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Groupon (Nasdaq: GRPN  ) is killing small business.

At least that's the case if you believe the owner of Back Alley Waffles. The business owner ran an offer through the deal site, but the start-up waffle house/art studio went out of business because it had to pay the costs of serving the waffles upfront, but Groupon spread out the payments to the company over three months.

I'll gladly pay you Tuesday for a hamburger today
The metric Back Alley Waffles failed to pay attention to is days sales outstanding, or DSO:

DSO = Current accounts receivable / (Sales for period / Days in period)

The formula calculates the number of days it takes for a business to collect for products or services it's already sold. Accounts receivable is essentially an interest-free loan to the customer, so keeping DSOs low is key to a healthy cash flow.

Investors should keep an eye on DSO for the companies they invest in. Too many sales to the Wimpys of the world and any business will go under, no matter how big or small.

Keep in mind, though, that different industries will have different standards for their DSOs. Coca-Cola (NYSE: KO  ) , for instance, had an average DSO of 36.7 days in 2011, while Pfizer (NYSE: PFE  ) had a DSO of 73 days during the same period. Clearly Coca-Cola is better at managing its cash, but it has different types of customers with different demands.

Comparing companies within an industry is fair game, though. Eli Lilly and Merck (NYSE: MRK  ) had average DSOs of 53.3 days and 59.3 days, respectively, trouncing Pfizer's ability to get paid quickly by its customers.

It's also helpful to check trends within a company. If a company can reduce its DSO, it can put its cash to work in other areas to grow its business. Pfizer's DSO was as high as 87.4 days in 2009, so at least the metric is headed in the right direction.

The flip side
While companies want to get paid for their services quickly, they also want to delay paying for things that they buy. That metric, days payable outstanding, or DPO, is calculated with this formula:

DPO = Accounts payable/Cost of goods sold per day

It's in Groupon's best interest to set up payment terms so it can hold onto the cash that it takes in before paying it out to the company it's running the offer for, because that allows the cash to be available to invest or pay other bills. In some industries, insurance companies for instance, investing customers' cash before paying it out is where much of their income comes from.

As long as you're not putting your customers out of business, of course
Which brings us back to the start of the article. Is Groupon putting its customers out of business?

Not directly, in the same way Wal-Mart is blamed for killing small business after moving into an area. I have sympathy for Back Alley Waffles, but no one forced the company to agree to the contract terms.

But indirectly? Maybe.

The company is in a tight spot since start-up businesses tend to be low on capital. In fact, according to the U.S. Small Business Administration, insufficient capital is one of the top reasons roughly 50% of small businesses fail within the first five years. Groupon has to tread lightly here if it wants businesses to be around to make another offer through the company again.

I've always had the same worry about payday lenders such as EZCorp, DFC Global, and Cash America. The occasional customer can afford to pay the high fees they charge on short-term loans if they're in a bind. But being a regular, repeat customer seems to be a recipe for financial ruin.

If Groupon can't afford to give small businesses better terms, maybe it needs to offer a cash-flow management course as a package deal with its offerings for small businesses.

This Fool is available to run the course. Just don't expect me to wait 90 days to get paid for it.

Fool contributor Brian Orelli won't get paid for writing this article for a few weeks, but he's OK with that because he knows how to calculate DSO. He holds no position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Coca-Cola. Motley Fool newsletter services have recommended buying shares of Pfizer and Coca-Cola. Motley Fool newsletter services have recommended creating a bull call spread position in Wal-Mart Stores. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 01, 2012, at 8:58 AM, TMFSkleegs wrote:

    I followed the Back Alley Waffles story, since I live nearby and had been thinking of checking it out. In this case, I think it's less of an issue about Groupon putting them out of business and more an issue of them not having a business license to begin with! A few days after the story came out, it was reported that Back Alley Waffles was operating illegally:

    To me, this just seems like a case of someone running their business poorly -- not getting the proper permits, and not reading the fine print when they agreed to a Groupon deal.

  • Report this Comment On August 01, 2012, at 4:23 PM, HumbleMan2 wrote:

    Why do not you tell your readers that the author of the Waffle house story withdrew his article the same day and replaced it with a more accurate version clearly showing that Groupon had paid them the full amount (around $5200) before they went out of business and that the total groupons used by bankrupcy time was less than that amout. In other words, this company actually sold less than $5200 to groupon holders.

    Of course, you are not interested in the truth. You started with an assumption and fished around for anything that could support it. Groupon is an advertisement vehicle and any company should carefully decide how to spend its advertisement dollars. If a company is run by morrons who decide to chew more than they could bite, is that Groupon's fault?

    This is just one instance of a series of shameful reporting we are seeing these days and it will not stop until some people start being held accountable and actually server some jail time before we can get back to honest reporting.

  • Report this Comment On August 04, 2012, at 12:40 PM, halina23 wrote:

    I wrote about Groupon possibly being bad for business in the following post to the Fool blog: I think small businesses really need to assess whether the advertising costs of a Groupon ad are justified in the number of new customers gained. There are also other ways to advertise a deal, such as by placing a coupon in the local paper, that are cheaper than going to Groupon.

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