- Cash flow or liquid cash is the engine that keeps the company running.
- It is like the human heart that ensures constant blood circulation to all the vital body organs.
- One would be dead within minutes if the heart stops. The same applies to cash flows and companies.
When a company can no longer meet its obligations as they become due, or venture into new profitable ventures due to its inability to attract cost effective cash flows, we say it is facing financial distress.
Cash flow or liquid cash is the engine that keeps the company running. It is like the human heart that ensures constant blood circulation to all the vital body organs. One would be dead within minutes if the heart stops. The same applies to cash flows and companies. Suppliers would insist on upfront payments or security and customers would be concerned about reliability of product supplies and quality. Talented employees would not want to work for a company with weak cash flows and viable partners would be reluctant to invest in the company. Banks will begin to go slow on new overdraft support or loan restructuring. Where credit is made available, it will be at exorbitant rates.
In the previous article published on Thursday, April 29 I mentioned that hiccups like cash flow distress are symptomatic of governance issues. In this article, I will demonstrate how governance, to large extent, is one of the main causes of cash flow distress hence business failures.
In my career as a corporate executive, I have come to identify four main avenues that kill cash flows, with some clearly intentional, while others are consequential. I have discussed them here below and the hallmark is that with strong governance systems in place, all of the causes of cash flow distress would be eliminated with ease.
To start with, most of the readers must have experienced at one time or the other, the push in favour of leasing arrangements as opposed to outright purchase. The proponents come with nice arguments about leasing being easy on the cash flows and that the whole amount is tax deductible. But, what they never tell you is that at the end of the lease term, you would have bought two or three similar assets.
The proponents also do not tell you that even with outright purchase one would still have access to tax benefits in the form of wear and tear allowance or investment allowance. The result is that you have an arrangement that is very expensive to run, very costly to terminate and with a very big hole in your cash flows. Good governance systems would subject such proposals to data and feasibility analysis and rigorous review and with every detail put under scrutiny.
Foreign denominated loan is another serious danger to prudent cash flow management. Proponents of foreign denominated loans always touch only on one side that is known- low interest rates. Indeed foreign denominated loans are cheap. In most offshore sources, loans are priced on London Inter Bank Rate (libor) plus margin, meaning if libor is 0.2 per cent per annum, and margin is four per cent per annum, the effective interest rate is only 4.5 per cent per annum.
Now compare this to the local commercial interest rates of 15 per cent per annum and you have a whopping 10 per cent per annum advantage with significant paper savings on interest payments. However, what they do not tell you is that if you have a dollar loan, you will have to pay it back in dollars, and this is where the trouble begins. You have zero dollar reserves, so you have to buy dollars. In all transactions, you will have foreign exchange gains and losses, and nine out of 10 they are losses. Therefore, you book foreign exchange losses, reflect very low interest payments, but take a huge hit on your cash flows due to these foreign exchange losses.
In situations where governance systems work as intended, the board will not allow a company to get into foreign exchange deals where one cannot demonstrate that the foreign debt repayments will be more or less offset with similar foreign currency cash inflows and that outflows are matched with inflows.
Probably the most threat to cash flows is executive fiat. This is where orders are from above and they have to be executed, and would explain some high turnover of finance executives in some companies. Executive fiat always override cash flow controls and there is normally not much avenues for redress as the system is chain linked. Financial analysis are performed with skewed data or no analysis is done at all. In such situations, suboptimal costly investment decisions are taken with no possibility of those investments paying back. In other words, you spend Sh10 million in a new asset but can only get back, throughout the productive life of that asset, Sh1 million. The Sh9 million is a hole in the company’s cash flows.
Finally, having poor working capital management systems, deriving from poor governance systems, will weigh heavily on cash flows with disastrous consequences. Companies that have some working system in place to help with day today cash flow management, however rudimentary, is most likely to emerge stronger. They will have a system on priority payments and target cash collections, and there is conscious effort to push collections. With weak systems, one would find long-term assets (expansions) being finance from operating short-term cash thereby exerting significant pressure on cash flows, with pilferage and stock losses abound.