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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LESSONS LEARNED #28: “Politicians love failure because no one ever asked government to fix something that was working.” -Old Pithy

Posted by PITHOCRATES - August 26th, 2010

THE TELEVISION SHOW Gomer Pyle, U.S.M.C. aired from 1964-1969.  It was a spinoff from the Andy Griffith Show.  Gomer, a naive country bumpkin who worked at Wally’s filling station, joined the Marines Corps.  And there was much mirth and merriment.  To the chagrin of Sergeant Carter, Pyle’s drill instructor (DI).  Think of Gunny Sergeant R. Lee Ermey’s Sergeant Hartman in the movie Full Metal Jacket only with no profanity or mature subject matter.  Sergeant Carter was a tough DI like Sergeant Hartman.  But more suitable for the family hour on prime time television.

Gunny sergeants are tough as nails.  And good leaders.  They take pride in this.  But sometimes a gunny starts to feel that he’s not himself anymore.  This was the subject of an episode.  And Gomer, seeing that Sergeant Carter was feeling down, wanted to help.  So he stuffed Sergeant Carter’s backpack with hay before a long march.  While the platoon was worn and tired, Sergeant Carter was not.  He was feeling good.  Like his old self.  Until he found out he was not carrying the same load his men were.  He asked Pyle, “why hay?”  He could understand rocks, but hay?  Because if he outlasted his men while carrying a heavier load, he would feel strong.  But knowing he had carried a lighter load only made him feel weak.

This is human nature.  People take pride in their achievements.  They don’t take pride in any achievement attained by an unfair advantage.  Self-esteem matters.  And you can’t feel good about yourself if you need help to do what others can do without help. 

AN OLD CHINESE proverb goes, “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.”  Let’s say I am a fisherman in a small village.  I catch fish to feed my family and sell/trade for other family needs.  There’s a man in my village who asks me for a fish each day so he can eat.  I’m a caring person.  So I give him a fish each day.  So a pattern develops.  Each day he shows up when I come in from my fishing.  He takes the fish and goes away.  It works out well for him.  He doesn’t have to work.  He can live off of my kind charity.  Then I move.  Without me being there to give him a fish each day, he no longer can eat.  And dies.  If I only had taught that man to fish. 

Kindness can lead to dependency.  And once dependent, you become lazy.  Why develop marketable skills to provide for yourself when someone else will provide for you?  The problem is, of course, what happens when that charity ends?  If you’re unable to provide for yourself and there is no longer someone providing for you, what do you do?  Steal?

Dependency and a lack of self-esteem are a dangerous combination.  And they feed off of each other.  This combination can lead to depression.  Behavioral problems.  Resentment.  Bitterness.  Envy.  Or a defeatist attitude.

These are often unintended consequences of government programs.  A failed program, then, has far reaching consequences beyond the initial economic costs of a program.

LIQUIDITY CRISES CAUSE a lot of economic damage.  If capital is not available for businesses to borrow, businesses can’t grow.  Or create jobs.  And we need jobs.  People have to work.  To support themselves.  And to pay taxes to fund the government.  So everyone is in favor of businesses growing to create jobs.  We all would like to see money being easy and cheap to borrow if it creates jobs.

But there is a downside to easy money.  Inflation.  Too much borrowing can create inflation.  By increasing the money supply (via fractional reserve banking).  More money means higher prices.  Because each additional dollar is worth a little less. This can lead to overvalued assets as prices are ‘bid’ up with less valuable dollars.  And higher prices can inflate business profits.  Looks good on paper.  But too much of this creates a bubble.  Because those high asset values and business profits are not real.  They’re inflated.  Like a bubble.  And just as fragile.  When bubbles burst, asset values and business profits drop.  To real values.  People are no longer ‘bidding’ up prices.  They stop buying until they think prices have sunk to their lowest.  We call this deflation.  A little bit of inflation or deflation is normal.  Too much can be painful economically.  Like in the Panic of 1907.

Without going into details, there was a speculative bubble that burst in 1907.  This led to a liquidity crisis as banks failed.  Defaults on loans left banks owing more money than they had (i.e., they became illiquid).  They tried to borrow money and recall loans to restore their liquidity.  Borrowers grew concerned that their bank may fail.  So they withdrew their money.  This compounded the banks problems.  This caused deflation.  Money was unavailable.  Causing bank runs.  And bank failures.  Business failures.  And unemployment grew. So government passed the Federal Reserve Act of 1913 to prevent a crisis like this from ever happening again.  The government gave the Federal Reserve System (the Fed) great powers to tweak the monetary system.  The smartest people at the time had figured out what had gone wrong in 1907.  And they created a system that made it impossible for it to happen again.

The worst liquidity crisis of all time happened from 1929-1933.  It’s part of what we call the Great Depression.  The 1920s had a booming economy.  Real income was rising.  Until the Fed took action.  Concerned that people were borrowing money for speculative purposes (in paper investments instead of labor, plant and material), they put on the brakes.  Made it harder and more expensive to borrow money.  Then a whole series of things happened along the way that turned a recession into a depression.  When people needed money, they made it harder to get it, causing a deflationary spiral.  The Great Depression was the result of bad decisions made by too few men with too much power.  It made a crisis far worse than the one in 1907.  And the Roosevelt administration made good use of this new crisis.  FDR exploded the size of government to respond to the unprecedented crisis they found themselves in.  The New Deal changed America from a nation of limited government to a country where Big Government reigns supreme.

ONE PROGRAM OF the New Deal was Social Security.  Unemployment in the 1930s ran at or above 14%.  This is for one whole decade.  Never before nor since has this happened.  Older workers generally earn more than younger ones.  Their experience commands a higher pay rate.  Which allows them to buy more things.  Resulting in more bills.  Therefore, the Great Depression hit older workers especially hard.  A decade of unemployment would have eaten through any life savings of even the most prudent savers.  And what does this get you?  A great crisis.

The government took a very atypical moment of history and changed the life of every American.  The government forced people to save for retirement.  In a very poor savings plan.  That paid poorly by comparison to private pensions or annuities.  And gave the government control over vast amounts of money.  It was a pervasive program.  They say FDR quipped, “Let them try to undo this.” 

With government taking care of you in retirement, more people stopped providing for themselves.  When they retired, they scrimped by on their ‘fixed’ incomes.  And because Social Security became law before widespread use of birth control and abortion, the actuaries of the day were very optimistic.  They used the birth rate then throughout their projections.  But with birth control and abortion came a huge baby bust.  The bottom fell out of the birth rate.  A baby bust generation followed a baby boom generation.  Actually, all succeeding generations were of the bust kind.  The trend is growing where fewer and fewer people pay for more and more people collecting benefits.  And these people were living longer.  To stay solvent, the system has to raise taxes on those working and reduce benefits on those who are not.  Or raise the retirement age.  All these factors have made it more difficult on our aged population.  Making them working longer than they planned.  Or by making that fixed income grow smaller.

FDR used a crisis to create Social Security.  Now our elderly people are dependent on that system.  It may suck when they compare it to private pensions or annuities, but it may be all they have.  If so, they’ll quake in their shoes anytime anyone mentions reforming Social Security.  Because of this it has become the 3rd rail of politics.  A politician does not touch it lest he or she wishes to die politically.  But it’s not all bad.  For the politician.  Because government forced the elderly to rely on them for their retirement, it has made the Social Security recipient dependent on government.  In particular, the party of government who favors Big Government.  The Democrats.  And with a declining birth rate and growing aged population, this has turned into a large and loyal voting bloc indeed.  Out of fear.

A PROGRAM THAT straddled the New Deal and LBJ’s Great Society was Aid to Families with Dependent Children (AFDC).  Its original New Deal purpose was to help widows take care of their children.  When program outlays peaked in the 1970s, the majority of recipients were unmarried women and divorced women.  Because this was a program based on need, the more need you had the more you got.  Hence more children meant more money.  It also reduced the importance of marriage as the government could replace the support typically provided by a husband/father.  Noted economist Dr. Thomas Sowell blames AFDC as greatly contributing to the breakdown of the black family (which has the highest incidence of single-parent households).

With the women’s liberation movement, women have come to depend less on men.  Some affluent women conceive and raise children without a husband.  Or they adopt.  And the affluent no doubt can provide all the material needs their children will ever need.  Without a husband.  Or a father for their children.  But is that enough?

The existence of ‘big brother’ programs would appear to prove otherwise.  Troubled children are often the products of broken families.  Mothers search for big brothers to mentor these fatherless sons.  To be role models.  To show an interest in these children’s lives.  To care.  When no such role models are available, some of these troubled children turn to other sources of acceptance and guidance.  Like gangs.

AFDC has compounded this problem by providing the environment that fosters fatherless children.  And another government program compounds that problem.  Public housing.

POOR HOUSING CONDITIONS hurt families.  They especially hurt broken families.  Without a working husband, these families are destined to live in the cheapest housing available.  These are often in the worst of neighborhoods.  This is an unfair advantage to the children raised in those families.  For it wasn’t their fault they were born into those conditions.  So, to solve that problem, government would build good public housing for these poorest of the poor to move into.  Problem solved.

Well, not exactly.  Public housing concentrates these broken families together.  Usually in large apartment buildings.  This, then, concentrates large numbers of troubled children together.  So, instead of having these children dispersed in a community, public housing gathers them together.  Where bad behavior reinforces bad behavior.  It becomes the rule, not the exception.  Making a mother’s job that much more difficult.  And because these children live together, they also go to school together.  And this extends the bad behavior problem to the school.  Is it any wonder that public housing (i.e., the projects) have the worst living conditions?  And some of the highest gang activity? 

Government didn’t plan it this way.  It’s just the unintended consequences of their actions.  And those consequences are devastating.  To the poor in general.  To the black family in particular.  AFDC and public housing enabled irresponsible/bad behavior.  That behavior destroyed families.  As well as a generation or two.  But it wasn’t all bad.  For the politicians.  It made a very large constituency dependent on government.

THERE ARE SO many more examples.  But the story is almost always the same.  Dependency and a lack of self-esteem will beat down a person’s will.  Like an addict, it will make the dependent accept poorer and poorer living standards in exchange for their fix of dependency.  Eventually, the dependency will reach the point where they will not know how to provide for themselves.  The dependency will become permanent.  As will the lack of self-esteem.  Conscious or not of their actions, Big Government benefits from the wretched state they give these constituencies.  With no choice but continued dependence, they vote for the party that promises to give the most.  Which is typically the Democrat Party.

But how can you fault these politicians?  They acted with the best of intentions.  And they can fix these new problems.  They’ll gather the brightest minds.  They’ll study these problems.  And they will produce the best programs to solve these problems.  All it will take is more government spending.  And how can you refuse?  When people are hungry.  Or homeless.  Or have children that they can’t care for.  How can anyone not want to help the children?  How can anyone not have compassion?

Well, compassion is one thing.  When the innocent suffer.  But when government manufactures that suffering, it’s a different story.  Planned or not the result is the same whenever government tries to fix things.  The cost is high.  The solution is typically worse than the original problem.  And the poorest of the poor are pawns.  To be used by Big Government in the name of compassion. 

Of course, if Big Government were successful in fixing these problems, they would fix themselves right out of existence.  So as long as they want to run Big Government programs, they’ll need a stock of wretched, suffering masses that need their help.  And, of course, lots of crises.

www.PITHOCRATES.com

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