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LACK OF LIQUIDITY: THE EARLY WARNING SIGNALS by LAURENCE N. GARTER, Partner, New York and FRANK J. ZOLFO, Partner, New York In recent years, many companies have expanded at a mercurial rate, only to be hurled on the rocks by the rough seas of an economic climate. Many of these companies drag down not only them-selves, but their stockholders and creditors, and affect even the financial institutions which support them. In most cases, the obvious cause of disaster is the company's loss of liquidity. The scenario in each case follows the same pattern. Operational problems cause an increase in current assets, which forces the need for increased debt. The financial institution reviews the financial statements and, based on traditional financial ratio analyses (tests of liquidity), furnishes the debt. Operational problems continue, current assets become no longer current, and the company defaults in debt payments. The financial institution again reviews the financial statements and determines that the company is no longer financially viable. There is a change in management, consultants are called in, turnaround plans are hurriedly prepared, and . . , the company fails. Over and over, the final scene is the same. The real problems surface too late to be solved. What are the early warning signs of a lack of liquidity? We suggest they are based on three premises: First, liquidity, in a real and pragmatic sense, can no longer be viewed as a series of historical financial ratios; it must be viewed in a "forward looking" perspective. Second, the traditional financial statement, viewed apart from operational analysis, is not an accurate and timely indicator of future viability. It merely reports the results of problems—too often after the problems have become too ingrained and difficult to correct. Third, proper management and operational reviews, combined with astute information analysis, can do much to avoid disaster. How To Define Liquidity A general purpose of the balance sheet—in addition to showing how the business has invested its money in various assets, and the sources of such funds—is to indicate probable liquidity. In this traditional context, liquidity refers to the convertibility of assets into cash and the ability to meet creditor obligations as they mature. The definition of liquidity, however, includes more than just the ability to convert assets into cash. We define liquidity as the ability: — To maintain effective management control — To sell the product in the future — To convert future sales into cash Sales to profits (P&L) Profit to cash (B/S) — To maintain the financial strength and credibility to ride out temporary problems that will occur. Thus defined, one cannot wait for the traditional annua! report to diagnose the financial health (liquidity) of the company. By the time such statements have indicated that a cancerous condition exists, the fatal disease can be too far advanced. Financial institutions as well as management, must rethink their traditional approach of measuring performance from only financial statement analyses. Mature companies should never find themselves in the midst of a liquidity problem. Enough options are available to provide management with the opportunity either to fix the problem in its early stages or, if necessary, to liquidate or sell all or part of the company before its market value decreases significantly. What safeguards are needed: — Timely, accurate management reporting to identify problems early. (This assumes more than a set of financial statements. Key non-financial operating data is a must.) — Astute management to respond to the warning signals revealed by proper management reporting, and to monitor progress against their plans, — Adequate financial strength to withstand non-growth. — Ongoing communication with financial institutions and suppliers, so that "they" can counsel management with the problems rather than be part of the problem. Why do some companies find themselves in irreversible hard times? Because some miss the early warning signs, and so fail to achieve a turnaround. While others correctly read the signals, but are frozen into inaction by the enormity of the problems. Still others react impulsively to the warning signals, slashing away at every expense. As a result, profitable and efficient programs are sacrificed, without identifying the real problems. Thus, a retailer who slashes payroll, merely buys time, because his real problem may be poor inventory control, poor site location, or a cash shortage stimulated by 49
Lack of liquidity: The Early warning signals
Garter, Laurence N.
Zolfo, Frank J.
|Abstract||Illustration not included in Web version|
Tempo, Vol. 23, no. 1 (1977), p. 49-51
|Source||Originally published by: Touche Ross, & Co.|
|Rights||Copyright and permission to republish held by: Deloitte|
|Format||PDF page image with corrected OCR scanned at 400 dpi|
|Collection||Deloitte Digital Collection|
|Digital Publisher||University of Mississippi Library. Accounting Collection|