Just as humans on a life support machine (oxygen) might live temporarily, businesses that rely on overdrafts, loans, government bailouts, need to rethink. Have you heard of gear and leverage? Simply defined as the receipts and payments from the operations of a business, the cash flow statement is intended to assist or provide an “invisible hand” to the day-to-day operations of an existing business entity and new businesses alike. This is especially important for small businesses that cannot raise funds in the short term. A company can generate large profits and yet it may not be liquid; you could 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 the current index or the fast asset 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 business in question. A company can be profitable and yet have cash flow problems.
I tell people that you can’t ‘eat’ their property, machines, probably your stock, or use it to pay your staff, suppliers or creditors. The guarantee of a guaranteed loan can be yes. But for how long? It doesn’t win the fact that most blue-chip auto companies like General Motors bowed to the recession in its early stages because they lacked the most liquid asset. 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 shares 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 primarily due to failures to have adequate liquid funds to continue. Although some banks have failed, at least some regulations are known to be in place to maintain funds for the “rainy day” capital adequacy ratio. MiFID; Basel I and II and the recent “stress test” instituted by the US government are just a few examples.
In light of this unexpected, shocking and surprising twist for so-called blue-chip companies, there should be some sort of regulatory mechanism directly monitored and controlled and maintained by central banks whereby companies hold some cash or reserves (which could easily converted to cash) being at least 2 years worth of wages and expenses from your business and personal operations. Alternatively, banks can run a scheme to guarantee staff salaries and business expenses. The benefits of this scheme would be enormous and definitely outweigh the costs. Socialism? Not far from it. It is still a mixed economy, but only 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’s too 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-Run Average Curve (LRAC) and will not achieve the usual U-shaped LRAC in the long run. I am in favor of correction. The survival of a business entity depends not so much on profit as on its ability to pay its debts when due and have cash available for its daily operations. Such payments may include not only profit and loss items, such as material purchases, salaries, interest, and taxes, but also principal payments for new non-current assets and repayments of loan principal when due, for example, in redemption of debentures.
