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Thursday, September 9, 2010

Can a growing, profitable company go out of business?

Yes, even a growing, profitable company can go out of business. Most small enterprises fail because of various reasons like - a poor business model, lack of distribution skills, inadequate market research, improper SWOT analysis. But the majority fail because of one simple reason. They run out of cash.

My favourite niece, a student of economics, came to me during her summer break to help her plan a small enterprise. She is very good at preparing cakes and pastries, and wanted to supply them to the myriad sweet-meat shops within a 3 KM radius from her home.

I told her to visit some of the more popular shops with her samples and find out whether they would be interested in stocking and selling her products, and what kind of terms they would offer. After about 10 days or so, she came with a beaming smile and a print-out of a spreadsheet.

“Uncle, we have a winner on our hands. You just need to fund my first month’s expenses. From the second month onwards, the venture will be in profits!” Without pouring cold water on her enthusiasm immediately, I decided to look at her figures. Here they are:

 

Month 1

Month 2

Month 3

Sales

6000

9000

13500

Raw Materials

3600

5400

8100

Gross Profit

2400

3600

5400

Expenses

3000

3000

3000

Net Profit

(600)

600

2400

“Looks pretty good. What kind of terms did you get from the grocer and the shops?” I asked. Being a smart kid, she had an answer ready. The grocer had extended a 30 days credit for the raw materials. The sweet-meat shops wanted 60 days credit from her.

“What are the expenses for?”, was my next question. She wanted to hire a person to help her in the kitchen, and to deliver the pastries and cakes to the shops and collect payment. The expenses included the cost of transportation.

“OK. But you do realise that you are not going to get paid for your efforts for two months? Have you figured out your actual cash requirements?” This time, she wasn’t prepared with an answer.

So, I started to explain patiently. In Month 1, the ‘Sales’ are on credit. The entire 6000 won’t be received. The ‘Raw Materials’ also won’t be paid for, and will remain due. But the expenses of 3000 need to be paid.

In Month 2, the ‘Sales’ are again on credit. No cash is received. The month’s ‘Raw Materials’ are not paid for, but the earlier month’s ‘Raw Materials’ worth 3600, plus the expenses of 3000 – a total of 6600 has to be paid out.

In Month 3, finally some cash comes in, the first month’s ‘Sales’ of 6000. But that isn’t enough to cover Month 2’s ‘Raw Materials’ of 5400, plus the expenses of 3000. A net amount of 2400 (= 8400 – 6000) has to be paid out.

From the Net Profit figures in the table above, the aggregate profits after Month 3 is 2400 (= –600 + 600 + 2400). An enterprise growing at 50% and making profits. But these profits are not ‘real’, just an accounting sleight of hand.

Actually, the cash paid out will be 12000 (= 3000 + 6600 + 2400). That is the only ‘real’ thing that will happen after all the activities of baking and delivering cakes and pastries for 3 months!

What would happen if some of the shops defer their payments? More cash would be required to cover the shortfall. What if my niece decides that such a growing and profitable business should be quickly expanded to other parts of the city? That would require additional expenses, multiplying the cash requirements.

This is a simplified example of a small enterprise, based on an imaginary conversation with my fictional niece. Now, change the ‘Month’ to ‘Year’ in the above table, and the figures to Rs Crores. Next, add a column for Year 4, where the sales drop by 50% while the ‘Raw Materials’ are already in inventory and ‘Expenses’ stay the same. What do you get? Suzlon Energy!

The point is: profits do not mean cash. Profits are more often than not fudged by company management and pliable auditors. It is much more difficult to fudge the cash flow statement – because it shows up in the ‘Cash and Bank balances’ of the Balance Sheet.

This is one of the main reasons that investors should check out the Cash Flow statement in an Annual Report before looking at the Balance Sheet and Profit and Loss statements. Needless to say, such due diligence should be done before buying a single share.

(Note: A friend who works as an accountant at a telecom services company, was late for a get-together last Saturday. “Were you working overtime with month-end closing figures?”, I asked. “No, no”, was his response. “We have kept August sales open till the 7th of Sept!” This kind of fudging is standard practice in many organisations.)

5 comments:

feltra (Raman R) said...

Excellent and very lucid example to explain necessity of cash flow, Subhankar ji....

But if we always insist on good cash flow, will it not mean missing out on some otherwise good companies? I do understand that "good companies" can become bad if the cash flow problems persist (like Punj Lloyd?)

Thanks & Best Regards,
-feltra

Subhankar said...

Appreciate your comments, Raman.

You have answered your own question. Why take chances with your hard-earned money?

Ruy said...

Subhankar da,
Excellent piece...you don't need any certificate from me though!
Just one question - just how important is "Economic Moat" or "Leadership position" in the business. Can economic moat/ leadership overrule cash flow problems, e.g. ICSA?
Regards
Sanjib Chakraborty

Subhankar said...

Thanks for your comments, Sanjib.

You have raised an interesting issue. I love companies that have wide economic moats and leadership positions. Opto Circuits is a good example of such a company.

Bottomline is - you have to monetise the advantage to maintain the lead. If the cash runs out, the company will go out of business or get acquired.

essentialassociate said...

Phenomenally simple idea that forms the basis of equity analysis. Would be all ears to your views in a few large cap companies with moats...