One of the questions I have been asked by many persons recently is how can a company as large as General Motors (GM) find itself in bankruptcy?
After all one would expect that a company as large as GM must have significant assets and have been very profitable over the years. So how does it get to that point of having to file for Chapter 11 protection, and seeing its shares trade below US$1.
The truth is that it can happen to any business that does not stay on top of managing their liquidity position. Many persons do not realize that they are in a liquidity trap, or never did, because they were able to disguise this by borrowing money. So while they were always having an underlying liquidity problem it was hidden by their ability to borrow. But one of the side effects of the credit crisis is that the ability to borrow was disrupted and when that happened many companies soon started to realize how exposed their balance sheet positions were.
So even though they were showing significant asset values on their balance sheets, the fact is that unless you are able to convert those assets to cash then it is like the blood leaving the body. Just as a body cannot survive without blood, a company (or individuals) cannot continue to operate if they run out of cash.
So what happened to GM was the same thing that happened to CLICO and the other large US financial institutions that failed in the recent credit crisis. The operations came to a standstill because they simply ran out of cash. So as I always say a company never goes out of business because it makes losses, but because it runs out of cash. For example, one could make significant profits but if you are unable to collect the sales then you will inevitably cease to operate.
This is why liquidity management is so important. Proper liquidity management does not start the day you can’t get money to borrow anymore, but from the first day you start doing business. It is more important to stay on top of your liquidity management than any other aspect of your business.
There are several ratios that the business person can use to manage his/her liquidity, which are called liquidity ratios. These include current ratio, acid test ratio, and days receivable ratio. In addition the business owner would want to monitor the receivables ageing and ensure that your costings are done properly so that you not only do not sell your goods for less than the cost, but also ensure that you manage your prices to consider inflation when replacing goods in the future.
A lot of this management of course requires good information systems and professional analysis, such as done by accountants. Hiring this expertise and putting good information systems in place is critical to avoiding future liquidity traps.
For the small business owner this may mean asking a professional accountant to set up certain ratios for you to look at and that can alert you to asking for greater analysis when these are out.
You can access expert advice and coaching on this by contacting us at www.mindyuhbusiness.com through the Contact Us menu.
By Dennis Chung, dennis@mindyuhbusiness.com
Thanks. We will continue to do so