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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Printing Money and Screwing Friends

Posted by PITHOCRATES - November 12th, 2010

My Coworker, the Cheap Canadian Bastard

I worked with a Canadian once.  A real cheap bastard.  Yeah, he had some financial issues.   But they weren’t my issues.  And I got tired of subsidizing his problems by driving him to lunch every day.  And I got tired of the conversations.  He brought up every negative story about America.  Belittled our president.  Chastised America for not signing on to the Kyoto Protocol.  And said that we did not honor our trade agreement concerning softwood lumber (that his government was subsidizing in order to undersell their American competitors).

What really bothered me was that he was a Canadian that lived near the border but worked in the U.S.  He criticized America but he chose to work in America instead of Canada.  Why?  Because he could get paid more in America.  And there were the perks of crossing the border every day.  He gassed his car up in the United States.  And his wife’s car.  Why?  Because our gas prices were cheaper.  Yeah, he would criticize America until he was blue in the face, but he took every opportunity to escape the taxes that paid for all those things that made his country superior to mine.

Now don’t get me wrong.  I like Canada.  I just don’t like hypocrisy.  He made good money over here.  And with a much more favorable exchange rate back then, that translated into big dollars on the other side of the border.  Back when the American dollar was strong and the Canadian dollar was weak, he did very well.  Those strong American dollars exchanged into a whole lot more Canadian dollars.  Which allowed him to buy a whole lot more stuff than his fellow Canadians.  In fact, a lot of Americans vacationed in Canada back then.  Because the American dollar bought more in Canada than it did in America.

Have Cheap Cash, Will Travel – In Canada

So what’s the point talking about this cheap bastard?  Exchange rates.  And whenever there’s a currency war on the horizon, I can’t help but think about this cheap bastard.  See how he, a Canadian working in America, lived very well with a cheap Canadian dollar.  We paid him in strong U.S. dollars.  He then could use those strong U.S. dollars to buy gas and other ‘less taxed’ items on the U.S. side of the border.  (If he brought in and exchanged weak Canadian dollars for strong U.S. dollars, that same amount of gas would cost him more.)  And when he took those strong U.S. dollars across the border back into Canada, he exchanged them and got so many weak Canadian dollars in return that he alone stimulated the local economy.

Of course, he wasn’t the only one bringing strong American dollars into Canada.  When those strong dollars were exchanged for weak ones, the Canadian tourism industry boomed.  People could vacation in Canada for a week for what a weekend in America would cost.  Canadians traveling into America, on the other hand, paid more for less.  A weekend in America would cost what a week in Canada would cost.

In the above example, you can see how the nation with the weaker currency has more economic activity than the nation with the stronger currency.  Now, to understand international trade and foreign exchange rates, make the following substitutions in the above example:

  • Canada -> America
  • America -> China/Germany/Brazil/other U.S. trading partner

Alone Against the World.  And Alan Greenspan

Well, America is devaluing their currency.  They’re printing money to buy back treasury debt.  Supposedly to stimulate the economy by injecting more liquidity. But our problem is not a liquidity problem.  It’s a lack of consumer spending because of high unemployment.  And a fear of being unemployed soon.  So this will do little to solve our problems.  But it will make our exports cheaper.  And our trading partners’ imports more expensive.  In other words, we’re trying to fix our broken economy by flooding our trading partners’ economies with cheap American goods.  Which is pissing them off big time (see Reuters’ Analysis: German tempers fray as U.S. policy gulf widens by Stephen Brown and Andreas Rinke posted 11/10/2010).

Finance Minister Wolfgang Schaeuble, 68, said last week that the U.S. Federal Reserve decision to buy $600 billion of government bonds undermined U.S. credibility and was “clueless.” There was no point, he said, in pumping money into the markets.

China and Brazil were among those echoing his comments but U.S. officials were particularly stung by Schaeuble and German Economy Minister Rainer Bruederle saying the Fed move amounted to “indirect manipulation” of the dollar to boost exports; this at a time when Washington is criticizing China for exactly the same kind of strategy.

“It’s not acceptable for the Americans to criticize China for currency manipulation then slyly help the dollar by printing at the Federal Reserve,” Schaeuble told Der Spiegel magazine.

And speaking of Brazil, President Luiz Inacio Lula da Silva said warned America not to rely on exports alone (see Brazil’s Lula Says World Headed For ‘Bankruptcy’ Unless Rich Nations Act posted 11/11/2010 on the Dow Jones Newswires).

“If they don’t consume, and they just bet on exports, the world will go into bankruptcy,” he told reporters as leaders at the Group of 20 industrial and developing nations headed into a two-day summit in the South Korean capital.

Even Alan Greenspan, former Federal Reserve Chairman, is expressing concern over the impact of American policy on foreign exchange rates (see Greenspan warns over weaker dollar by Alan Beattie in Seoul posted 11/10/2010 in the Financial Times).  In that same article, Mervyn King, governor of the Bank of England, warned that this currency manipulation could trigger a trade war that would make the next 12 months worse than the previous 12 months.

We’re All Cheap Bastards Now

When it comes down to it, I guess we’re all cheap bastards.  We all want some unfair advantage in life.  Like my one-time Canadian coworker.  And I can understand how our trading partners feel.  I’ve worked with and been lectured for years about how my country should change.  All the while he prospered quite handsomely from the way things were.  Of course, I can take some solace in the dollar’s slide.  It’s trading pretty much at parity with the Canadian dollar now.  It’s gotten so bad that I’ve heard my old friend has since found work on his side of the border.  Good for him.  Now he can truly embrace all those taxes that he spoke so highly about while he was avoiding them for all those years.

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