Just as human beings who receive a life support machine (oxygen) could live temporarily, companies that depend on overdrafts, loans, government bailouts, need a rethink. Have you heard of gear and leverage? Simply defined as the receipts and payments of a business’s operations, the cash flow statement is intended to assist or provide an “invisible hand” to the day-to-day operations of both an existing and a new business entity. This is especially important for small businesses that cannot raise funds in the short term. A company may generate large profits and yet may not be liquid; you might be hungry for cash. Therefore, profitability does not necessarily mean liquidity.
Profitability is an accounting concept measured using net profit margin or gross profit margin. Liquidity is the ability to convert current assets into cash or “legal tender” for a company’s operations with ease. It is measured using either the Current Index or the Quick Assets Index. This is important because the financing of current assets depends on the level or amount of short-term financing and its sources of financing. These should also be planned in relation to the cash flow generation of the company in question. A company can be profitable and yet have liquidity problems.
I tell people that you can’t ‘eat’ their property, machines, probably their stock, or use it to pay your staff, suppliers or creditors. The collateral for a secured loan can be yes. But for how long? It doesn’t win that most blue-chip auto companies like General Motors bowed to the recession in its early stages because they lacked the most liquid assets. Its failures could, among other things, be attributed to an overreliance on the stock price (the demand side) of market capitalization. The reason is obvious: when consumer confidence and investor demand for stocks fell, their market capitalizations fell and the rest is what we are all witnessing and feeling now.
Most of the big auto companies that collapsed during the current recession were mainly due to failure to have adequate liquid funds to continue. Although some banks failed, at least some regulations are known to exist to hold funds for the “rainy day” capital adequacy ratio. MiFID; Basel I and II and the recent “stress test” instituted by the US government are some examples.
In light of this unexpected, shocking and surprising turnaround for so-called blue-chips, there should be some kind of regulatory mechanisms directly monitored and controlled and maintained by central banks whereby companies hold some cash or reserves (which could be converted into easily in cash) being at least 2 years of wages and expenses from your business operations and personal. Alternatively, banks can run a scheme to guarantee staff salaries and business expenses. The benefits of this scheme would be huge and definitely outweigh the costs. Socialism? Not far from it. It is still a mixed economy, but only by being more cautious so that the excesses of a few do not bring down the entire economy and thus bring untold hardship to the masses.
Principles are principles, they may not work once, but they work most of the time. The recently introduced ‘stress test’ by the US is reported to have been successful (although it is early to tell). However, governments that intend to ‘copy’ the US ‘stress test’ environment and also wait for the ‘dust’ to settle.
The business cycle is real, but it could somehow be manipulated or managed well. Economists will tell us that a company can enjoy economies of scale for a long time if it knows what can generate diseconomies of scale; they can be manipulated or managed by the company to maintain the L-shaped Long-Term Average Curve (LRAC) and you will not get the usual U-shaped LRAC in the long run. I am in favor of the correction. The survival of a business entity depends not so much on profits as on its ability to pay its debts when they come due and have cash available for its daily operations. Such payments may not only include profit and loss items, such as material purchases, salaries, interest and taxes, but also principal payments for new non-current assets and principal repayments of loans when due, for example on redemption of debentures.