Lack of liquidity: The Early warning signals;

              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problems continue, current assets become no longer
current, and the company defaults in debt payments.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
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