Small Business Cash Flow Issues - how to identify earlier?

A recent article on bankruptcy for small businesses in the Wall Street Journal reminded me of an issue that almost all small businesses face at some point in the organization's life. That issue is the management of cash flow, most importantly, the lack of it.

Typically, a traditional privately held small business will rarely have received equity financing from sources such as angel investors or venture capitalists. Instead, most small businesses are dependent on the founder's own funds, credit cards, re-invested profits, and a local community bank. Funds from banks are typically traditional loans for working capital like inventory, accounts receivable, or longer term loans for purchases of buildings, machines and other non-current assets. As recent history shows (i.e., pandemic) almost all businesses suffered cash flow problems despite their grandest efforts.

There are a variety of methods banks and other financial institutions utilize to monitor cash flow efficiency both before providing financing and in monitoring ongoing company performance that could affect its ability to pay off the loan. Specifically, this post will briefly review some financial ratios used to monitor liquidity and highlight some of the issues that can arise from those ratios. It will then re-focus on a lesser used but highly effective liquidity measurement that assists in addressing traditional issues.

Financial Ratios in Liquidity Monitoring - A Review

1. Current Ratio: (Current Assets/Current Liabilities). The old rule of thumb was a +2 or higher was good. This varies by industry and economic conditions.

2. Quick Ratio: (Current Assets- Inventory)/Current Liabilities. Taking out the effect of Inventory as for a lot of businesses, it is not quickly convertible to cash. Rule of thumb, +1 or higher.

Issues with Ratios in Liquidity Monitoring

The Current and Quick Ratios are effective in their simplicity and that they focus on the current sections of the balance sheets. However, most small businesses are cash businesses with low levels of accounts receivable and may not possess inventory. As a result, if the business keeps cash levels low to reinvest back into the business, current liabilities will be relatively high compared to current assets. A firm could be highly profitable but have very poor Current and Quick Ratios due to their working capital management policies. Also, many small businesses rely on the Accounts Payable to 'float' or fund the some or all of their assets, not just Current Assets. Small businesses are notoriously undercapitalized with long-term debt and equity, letting Payables rise to be the company's funding source.

An Alternative - Net Balance Position

In the Entrepreneurial Management course taught by Professor Emeritus Bob Pricer and continued by the author of this blog, a liquidity ratio called Net Balance Position (NBP) has been taught for over four decades. The NBP measurement (calculation discussed in greater detail here) possesses strengths over the traditional liquidity measures in a couple of ways. First, it includes the entire balance sheet of the small business (both current and non-current portions) as a measure of liquidity. Second, it provides a bottom line answer in Currency to identify the liquidity situation (if > or equal to Zero, considered liquid). Third, it can be operationalized suggesting that looking at the major components of the ratio, owners/managers can easily see the impact their decisions and actions may have.

Does It Work?

In a research study conducted in the early 2000s, Professor Pricer and staff measured the effectiveness of using the NBP metric in predicting loan performance of several hundred businesses with loans at a Midwest Regional Bank as compared to the Current and Quick Ratios and a common bankruptcy predictor, the Altman Z-Score. The results were favorable with the NBP indicating an accuracy rate of +90% as compared to the other predictors (most with 50% or less). The other ratios used were typically applied by the credit analysts/managers in monitoring loan performance.

In the study, the bankers layered on credit analyst judgement as an additional criteria to their traditional credit rating methods. The NBP accuracy was still much higher than the ratios plus the judgment of the bankers.

A copy of the research article is presented below:

JABE Article.pdf

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