Trend Analysis – Liquidity

Posted by PITHOCRATES - January 7th, 2013

Economics 101

Liquidity can be More Important than Profitability to a Small Business Owner

Small business owners lose a lot of sleep worrying if they will have enough cash for tomorrow.  For next week.  For next month.  You can increase sales and add new customers but unless this creates cash those new sales and new customers may cause more problems than they help.  For a lot of businesses fail because they run out of cash.  Often times learning they have a cash problem only when they don’t have the cash to pay their bills.  So savvy business owners study their financial statements each quarter.  Even each month.  Looking for signs of trouble BEFORE they don’t have the cash to pay their bills.

Investors poor over corporations’ financial statements to make wise investment decisions.  Crunching a lot of numbers.  Analyzing a myriad of financial ratios.  Gleaning a lot of useful information buried in the raw numbers on the financial statements.  Small business owners analyze their financial statements, too.  But not quite to the extent of these investors.  They may look at some key numbers.  Focusing more on liquidity than profitability.  For profits are nice.  But profits aren’t cash.  As a lot of things have to happen before those profits turn into cash.  If they turn into cash.  The following are some balance sheet and income statement accounts.  Following these accounts are some calculations based on the values of these accounts.  With four quarters of data shown.

So what do these numbers say about this year of business activity?  Well, the business was profitable in all four quarters.  And rather profitable at that.  Which is good.  But what about that all important cash?  With each successive quarter the business had a lower cash balance.  That’s not as good as those profitability numbers.  And what about accounts receivable and inventory?  There seems to be some large changes in these accounts.  Are these changes good or bad?  What about accounts payable?  Accrued expenses?  Current portion of long-term debt?  These all went up.  What does this mean in the grand scheme of things?  Looking at these numbers individually doesn’t provide much information.  But when you do a little math with them you can get a little more information out of them.

In Trend Analysis a Downward sloping Current Ratio indicates a Potential Liquidity Problem

Current assets are cash or things that a business can convert into cash within the next 12 months.  Current liabilities are things a business has to pay within the next 12 months.  Current assets, then, are the resources you have to pay your current liabilities.  The relationship between current assets and current liabilities is a very important one.  Dividing current assets by current liabilities gives you the current ratio.  If it’s greater than one you are solvent.  You can meet your current financial obligations.  If it’s less than one you will simply run out of current resources before you met all of your current liabilities.  In our example this business has been solvent for all 4 quarters of the year.

Days’ sales in receivables is one way to see how your customers are paying their credit purchases.  The smaller this number the faster they are paying their bills.  The larger the number the slower they are paying their bills.  And the slower they pay their bills the longer it takes to convert your sales into cash.  Days’ sales in inventory tells you how many days of inventory you have based on your inventory balance and the cost of that inventory.  The smaller this number the faster things are moving out of inventory in new sales.  The larger this number is the slower things are moving out of inventory to reflect a decline in sales.  These individual numbers by themselves don’t provide a lot of information for the small business owner.  Big corporations can compare these numbers with similar businesses to see how they stack up against the competition.  Something not really available to small businesses.  But they can look at the trend of these numbers in their own business and gain very valuable information.

The above chart shows the 4-quarter trend in three important liquidity numbers.  Days’ sales in receivables increased after the second quarter upward for two consecutive quarters.  Indicating customers have paid their bills slower in each of the last two quarters.  Days’ sales in inventory showed a similar uptick in the last two quarters.  Indicating a slowdown in sales.  Both of these trends are concerning.  For it means accounts receivable are bringing in less cash to the business.  And inventory is consuming more of what cash there is.  Which are both red flags that a business may soon run short of cash.  Something the three quarters of falling current ratio confirm.  This business is in trouble.  Despite the good profitability numbers.  The downward sloping current ratio indicates a potential liquidity problem.  If things continue as they are now in another 2 quarters or so the business will become insolvent.  So a business owner knows to start taking action now to conserve cash before he or she runs out of it in another 2 quarters.

Keynesian Stimulus Spending can give a Business a Current Ratio trending towards Insolvency

In fact, this business was already having cash problems.  The outstanding balance in accounts payable increased over 100% in these four quarters.  Not having the cash to pay the bills the business paid their bills slower and the balance in outstanding accounts payable rose.  Substantially.  As the cash balance fell the business owner began borrowing money.  As indicated by the increasing amounts under current portion of long-term debt and interest expense.  Which would suggest substantial borrowings.  Putting all of these things together and you can get a picture of what happened at this business over the past year.  Which started out well.  Then experienced a burst of growth.  But that growth disappeared by the 3rd quarter.  When sales revenue began a 2-quarter decline.

Something happened to cause a surge in sales in the second quarter.  Something the owner apparently thought would last and made investments to increase production to meet that increased demand.  Perhaps hiring new people.  And/or buying new production equipment.  Explaining all of that borrowing.  And that inventory buildup.  But whatever caused that surge in sales did not last.  Leaving this business owner with excess production filling his or her inventory with unsold goods.  And the rise in days’ sales in receivables indicates that this business is not the only business dealing with a decline in sales.  Suggesting an economic recession as everyone is paying their bills slower.

So what could explain this?  A Keynesian stimulus.  Such as those checks sent out by George W. Bush to stimulate economic activity.  Which they did.  Explaining this sales surge.  But a Keynesian stimulus is only temporary.  Once that money is spent things go right back to where they were before the stimulus.  Unfortunately, this business owner thought the stimulus resulted in real economic activity and invested to expand the business.  Leaving this owner with excess production, bulging inventories, aging accounts receivable and a disappearing cash balance.  And a current ratio trending towards insolvency.  Which is why Keynesian stimulus spending does not work.  Most businesses know it is temporary and don’t hire or expand during this economic ‘pump priming’.  While those that do risk insolvency.  And bankruptcy.


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Statement of Cash Flows

Posted by PITHOCRATES - December 18th, 2012

Economics 101

No Business will be able to Repay any Loan unless their Business Operations can Generate Cash

In business cash is king.  As it is in life.  We need cash to buy food to survive.  Just as a business needs cash to pay its bills to survive.  Cash is so important to a business that there is a special financial statement to summarize cash flows in a business.  It looks something like this.

The above are made up numbers that could be similar to any statement of cash flows.  It shows the three sources of cash for a business.  Operating activities.  Investing activities.  And financing activities.  Every last dollar a business has came from one of these three sources.  And we can determine the health of the business just by seeing where its cash came from.

Not all business owners use a statement of cash flows.  Most small business owners probably don’t.  Having some other method to see where their cash is coming from.  And going to.  But if they plan on borrowing money from a bank they’re going to need one.  As bankers want to see a business’ ability to generate cash from their business operations.  For no business will be able to repay any loan unless their business operations can generate cash.

An Increase in Accounts Receivable indicates a Business’ Customers are Paying them Slower

A business generates cash from operating activities.  Which comes from sales.  Of course business have to spend a lot of money to create those sales.  So the net cash generated is basically net income with a few adjustments.  In accrual accounting we expense a portion of what we spent on an asset as a depreciation expense each accounting period.  Because although we pay for an asset in one year we may use that asset for the next 5 years.  Or more.   So we expense a portion of that asset each accounting period.  But we don’t have to write a check to pay for depreciation.  It is a non-cash transaction.  So to adjust net income to show net cash generated we have to add back this depreciation expense.

An increase in accounts payable indicates a business is paying their bills slower.  And when you pay your bills slower you free up cash for other things.  Becoming a source of cash.  With each payroll a business has to withhold taxes from their employees’ paychecks.    Social Security, Medicare, unemployment insurance, the employee’s federal and state withholding taxes.  With each payroll these liabilities accrue and are payable to the various government agencies.  You  can free up some cash by paying these taxes late.  But it is not recommended.  For the penalties for doing so can be severe.

An increase in accounts receivable indicates their customers are paying them slower.  An increase in inventory indicates they’re buying more into inventory than they’re selling from inventory.  Prepayments will conserve cash in the future by paying for things now.  But they will leave you with less cash now.  A decrease in accrued liabilities indicates they’re catching up on paying some of their accrued expenses.  Like those payroll taxes.  (In the ideal world if you add up the increase and decrease in accrued liabilities they should net out. Indicating you’re paying your accrued expenses on time.  In this example the business has a balance of $3,000 they’re paying late.)  Increases in all of these items consume cash, leaving the business with less cash for other things.

When the Owner has to put in More of their Own Cash into the Business Things are not going Well

Cash flows from investing activities can include financial investments a business buys and sells with the excess cash they have.  In this example the only investment activities is the buying and selling of some plant assets.  Perhaps selling some old equipment that is costly to maintain and replacing it with new equipment.  Even replacing a vital piece of production equipment that breaks down.  Putting a business out of business.  Thus requiring a cash purchase to replace it as quickly as possible.  Short-term borrowing may be advances on their credit line while the settlement on short-term debt may be the repaying of some of those advances.  Proceeds from long-term debt may be a new bank loan.  While payments to settle long-term debt may be repaying a previous loan.  Finally, paid-in capital is money from the business owner.  Such as cashing in a 401(k) or getting a second mortgage on their house so they can put it into their business to make up for a cash shortage.

So what does all of this mean?  Is this business doing well?  Or are they having problems?  Well, the good news is that they are meeting their cash needs.  The bad news is that it’s not because of their operating activities.  They’re meeting their cash needs by paying their vendors slower.  In fact, if they didn’t they may have had a net loss of cash for the year.  Which means had they not paid their bills late they may have gone bankrupt.  And their cash problems are evident elsewhere.   For not only are they paying their vendors slower their customers are paying them slower.  Making them wait longer to get the cash from their sales.  And with more money going into inventory than coming out of inventory it indicates that sales are down.  Leaving them with less revenue to convert into cash.  And what’s particularly troubling is that increase in accrued liabilities.  Which could mean they’re paying their payroll taxes slower.  Accessing their credit line also indicates a cash problem.  Also, having to borrow $50,000 to help repay a $100,000 loan coming due is another sign of cash problems.  Finally, when the owner has to put in more of their own cash into the business things are not going well.

These are things a business owner has to deal with.  And things a loan officer will note when reviewing the statement of cash flows.  Some people may think a net increase in cash of $18,000 is a good thing.  But it’s not that good.  Considering they had to get that cash by paying their vendors slower, paying the government slower, borrowing money as well as investing more of their personal savings into the business.  Worse, despite having all of these cash problems the government is taxing away of lot of their cash.  Because their net income passing through to their personal income tax return is $235,000.  Putting them in the top 5% of income earners.  And into the crosshairs of those looking to raise tax rates on those who can afford to pay a little more.  To make sure they pay their ‘fair’ share.


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Accounts Payable and Accounts Receivable

Posted by PITHOCRATES - November 26th, 2012

Economics 101

Someone’s Account Payable is Someone’s Account Receivable

Cash is king in small business.  Because without it you can’t make payroll or pay your payroll taxes.  As important as cash is, though, many business will never grow until they start offering credit.  Trade credit.  Selling things on account.  Because for those doing repeat business it is just too much of a pain to write a check for every purchase.  And it’s just dangerous carrying around that kind of cash.  So businesses offer credit to established customers.  Those with good credit.  And good reputations.

Customers open an account.  When they make a purchase they get an invoice generally payable in 30 days.  Or some number of days around that.  At the end of the month they will receive a statement from their vendor showing all of their open invoices.  Which they will compare with their accounting records.  By running their accounts payable report.  And they will compare the invoices they show outstanding with those on their vendor’s statement.   They will resolve any differences.  And then write a check for their outstanding invoices.

On the other end of the sale there is an account receivable.  For someone’s account payable is someone’s account receivable.  A sale that doesn’t bring cash into the business.  But a promise to pay cash within a short amount of time.  So a business can greatly increase sales by offering trade credit.  By being a mini-banker.  Their sales revenue will grow.  As will their net profit.  But not necessarily their cash in the bank.  For it will look good on paper.  But until they convert those accounts receivable into cash it will only be on paper.  And money on paper is just not as good as money in the bank.

When Invoices are Unpaid for 90 Days or More there’s a Good Chance they will Never be Paid

There is a certain euphoria small business owners feel when they see their sales grow.  Things are moving in the right direction.  All their hard work is paying off.  Finally.  Some even fantasize about spending some of that money.  Such as going out to lunch on Friday instead of brown-bagging it every day of the week.  Then some anxiety starts growing.  And it comes from their accounts receivables report.  When they see that 30 days after those sales come and go.  And a lot of those open invoices remain on the report.

The accounts receivable report small business owners review is called an aging report.  Because it shows what invoices are current, which are 30 days old, which are 60 days old and which are 90 days or more old.  And when invoices are unpaid for 90 days or more there’s a good chance they will never be paid.  In fact, once they pass 30 days the chances that their customers won’t pay them grow greater.  And this is the source of a small business owner’s anxiety.  When he or she sees those invoices move from 30 days to 60 days to 90 days.

Why do some customers pay slower than others?  Because they, too, have accounts receivable moving from 30 days to 60 days to 90 days.  And if they’re not collecting their money in a timely manner then can’t pay their bills in a timely manner.  When the economy slows down you will see a lot of businesses start to pay their bills slower.  And as they pay their bills slower businesses collect their money slower.  Which forces them to pay their bills slower.  Or, worse, borrow money to pay their bills until their customers pay theirs.

To encourage their Customers to Pay their Bills Timely many Businesses will offer Early Payment Discounts

Sales are great.  Everything that’s good follows from sales.  Sales are the first step in creating cash.  And cash is king.  But between cash and sales are accounts receivable.  Which can make or break any small business.  For you can’t often grow sales without extending credit.  But if you extend too much credit and/or your customers don’t pay their bills a business owner can lose everything he or she worked for.  Because when it comes down to it, sales are great but cash is king.

To encourage their customers to pay their bills timely many businesses will offer early payment discounts.  If the customer pays their invoice within 10 days, say, they will get a 2% discount on that invoice.  So if they have a $1000 invoice they only have to pay $980.  As an owner will trade $20 in profits to speed up their cash collections.  And if you look at some numbers you can see why.  If they have $150,000 in new sales in one month that 2% discount will cost them $3,000 in profits.  Now compare that to the cost of borrowing cash from an 11% credit line to replace the cash they can’t collect from their customers.  If they have receivables of $150,000 at 30 days, $300,000 at 60 days and $49,950 at 90+ days the interest cost to borrow money to replace these funds can add up to $3,322.46.

So an early payment discount can equal a business’ borrowing costs.  Making it a wash.  While offering a huge benefit.  Allowing a business to pay their bills.  Like payroll.  Payroll taxes.  And their vendors.  For in difficult economic times all businesses have cash problems.  And will do almost anything to improve their cash position.  And when it comes to paying their bills and they can’t pay them all guess which ones they’re going to pay first?  Those that help their cash position.  That is, those invoices that offer an early payment discount.  Because sales are great.  But cash is king.


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Stocks and Bonds

Posted by PITHOCRATES - January 9th, 2012

Economics 101

When Companies grow their Capital Requirements grow beyond a Bank’s Lending Ability

We note a civilization as being modern when it has vigorous economic activity.  Advanced economies around the world all have the same things.  Grocery stores.  Clothing stores.  Electronic stores.  Appliance stores.  Coffee shops and restaurants.  Factories and manufacturing plants.  And lots and lots of jobs.  Where people are trading their human capital for a paycheck.  So they can take their earnings and engage in economic activity at these stores, coffee shops and restaurants.

To buy things off of shelves in these stores things have to be on those shelves first.  Which means selling things requires spending money before you earn money.  Businesses use trade credit.  Such as accounts payable.  Where a supplier will give them supplies and send them an invoice typically payable in 30-90 days.  They will establish a credit line at their bank.  Where they will borrow from when they need cash.  And will repay as they collect cash (such as when their customers pay their accounts payable).  And take out loans to finance specific things such as a delivery van or restaurant equipment.

Businesses depend on their bank for most of their credit needs.  But when companies grow so do their capital requirements.  Where capital is large amounts of money pooled together to purchase property, buildings, machinery, etc.  Amounts so great that it exceeds a bank’s ability to loan.  So these businesses have to turn to other types of financing.  To the equity and debt markets.

Investors Invest in Corporations by Buying their Stocks and Bonds

Equity and debt markets mean stocks and bonds.  Where we use stocks for equity financing.  And bonds for debt financing.  Stocks and bonds allow a corporation to spread their large financing needs over numerous people.  Investors.  Who invest in corporations by buying their stocks and bonds.

When a business ‘goes public’ they are selling stock in their company for the first time.  We call this the initial public offering (IPO).  If the company has a very promising future this will bring in a windfall of capital.  As investors are anxious to get in on the ground floor of the next big thing.  To be a part of the next Microsoft.  Or Apple.  This is when a lot of entrepreneurs get rich.  When they are in fact the next big thing.  And if they are, then people who bought stock in their IPO can sell it on the secondary market.  Where investors trade stocks with other investors.  By buying low and selling high.  Hopefully.  If they do they get rich.  Because the greater a company’s profits the greater its value and the higher its stock price.  And when a company takes off they can sell their stock at a much higher price than they paid for it in the IPO.

When a corporation needs to borrow more than their bank can loan and doesn’t want to issue new stock they can sell bonds.  Which breaks up a very large amount into smaller amounts that investors can buy.  Typically each individual corporate bond has a face value of $1000.  (So a ten million dollar ‘loan’ would consist of selling ten thousand $1,000 bonds).  Like a loan a corporation pays interest on their bonds.  But not to a bank.  They pay interest to the investors who purchased their bonds.  Who can hold the bonds to maturity and collect interest.  Or they can trade them like stock shares.  (Changes in the interest rates and/or corporate financial strength can change the market value of these bonds.)  When a bond reaches maturity (say in 20 years) the company redeems their bonds from the current bondholders.  Hopefully with the new profits the bond issue helped to bring into the corporation.  Or they just issue new bonds to raise the money to redeem the older bonds.

A Company Usually has a Mix of Equity and Debt Financing that Balances all the Pros and Cons of Each

There are pros and cons to both equity and debt financing.  Selling stock transfers ownership of the company.  Sell enough so that someone can own more than 50% and that someone can replace the board of directors.  Who in turn can replace the CEO and the other corporate officers.  Even the business founder.  This is the big drawback of going public.  Founders can lose control of their company.

Stocks don’t pay interest.  So they are less threatening during bad economic times.  As business owners, stock shareholders are there for the long haul.  During the good times they may expect to collect dividends (like an interest payment).  During bad times they will wait it out while the company suspends dividend payments.  Or, if they lose confidence, they’ll try and sell their stock.  Even at a loss.  To prevent a future greater loss.  Especially if the corporation goes bankrupt.  Because stockholders are last in line during any bankruptcy proceedings.  And usually by the time they pay off creditors there is nothing left for the shareholders.  This is the price for the chance to earn big profits.  The possibility to lose everything they’ve invested.

Bonds are different.  First of all, there is no transfer of ownership.  But there is a contractual obligation to make scheduled interest payments.  And if they fail to make these payments the bondholders can force the company into bankruptcy proceedings.  Where a corporation’s assets can be liquidated to pay their creditors.  Including their bondholders.  Which, of course, often means the end of the corporation.  Or a major restructuring that few in management enjoy.

Stockholders don’t like seeing their share value diluted from issuing too many shares.  Bondholders don’t like to see excessive debt that threatens the corporation’s ability to service their debt.  So a company usually has a mix of equity and debt financing that balances the pros and cons of each.  A financing strategy that has been working for centuries.  That allows the advanced civilized world we take all too much for granted today.  From jetliners.  To smartphones.  To that new car smell.  For none of these would be possible without the capital that only the equity and debt markets can raise.


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