Risky customers – Watch out for signs of disappearing cash

Forget net income and book net worth. When it comes to monitoring creditworthiness, cash is king. Every business experiences occasional cash shortfalls — that’s why they need lines of credit — but borrowers with chronic cash deficits may be on the brink of default.

Check out the statement of cash flows

Although business owners and lenders tend to cast it aside, the statement of cash flows can reveal clues about an existing or prospective borrower’s performance, especially the owner’s ability to manage cash. The statement of cash flows typically consists of three sections:

  • Cash flows from operations. This section converts accrual net income to cash provided or used by operations. All income related items flow through this part of the cash flow statement, such as net income; gains (or losses) on asset sales; depreciation and amortization; and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables.
  • Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up here. This section could reveal whether a company is divesting of assets for emergency funds or whether it’s reinvesting in future operations.
  • Cash flows from financing activities. The third section shows transactions with investors and lenders. Examples include treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.

Below these three categories is the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.

Inquire about significant changes

The statement of cash flows shows changes in balance sheet items from one accounting period to the next. Lenders should inquire about significant balance changes. For example, if accounts receivable were $1 million in 2007 and $2 million in 2008, the change would be reported as a cash outflow from operations of $1 million. That’s because more money was tied up in receivables in 2008 than 2007.

An increase in receivables is common for growing businesses, because receivables generally grow in proportion to revenue. But a mounting receivables balance also might signal cash management inefficiencies. Additional financial information — such as an aging schedule — might reveal significant write-offs, which is important information if you’re a lender that relies on accounts receivable as collateral.

Also beware of businesses that continually report negative cash flows from operations. There is a limit to how much money a company can get from selling off its assets, issuing new stock or taking on more debt. When operating cash outflows consistently outpace operating inflows, it’s time for intervention.

Find hidden sources of cash

Outside financial professionals can breathe new life into a cash-starved business. And their expertise is in high demand during economic downturns. Here are some ways they can help borrowers stave off the cash crunch:

Control growth.

Companies that grow too fast experience growing pains. Cash shortages result from the operating cycle: Before they receive payment from customers, they must fork out substantial sums to pay employees, rent facilities, build product, etc. Out-of-control growth also can impair quality, which, in turn, hurts goodwill and long-term viability.

Putting the brakes on growth may be a hard pill for entrepreneurs to swallow. But slow sustainable growth usually is better over the long term. An accountant can help borrowers compute their “fundable growth rate,” the growth rate at which cash inflows equal cash outflows.

Trim fat.

Struggling companies can restore cash reserves by curbing quasi-business expenses (such as luxury vehicles and business trips), laying off nonessential workers, avoiding advance purchases, selling off nonoperating assets or repaying shareholder loans.

Convert expenses from fixed to variable.

For example, borrowers might consider outsourcing, temporary labor and equipment leasing to generate cash. They also might re-evaluate their tax planning strategies, which may be outdated under current economic conditions and the new U.S. administration.

Upgrade asset management.

A financial professional can identify weaknesses in asset management and offer solutions. For example, accounts receivable collections might improve with tighter credit policies, early-bird discounts, collections-based compensation programs and dedicated collections personnel.

Conversely, some companies carry too much inventory. (See “Lean companies are healthy borrowers” below.) In addition to tying up working capital, inventory incurs hidden costs, such as interest, storage and insurance expenses.

Keep a watchful eye

By donning their detective caps, lenders can prevent unwise credit decisions. For existing borrowers, your diligence can identify problems and help find solutions that minimize the risk of default.

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