A Cash Flow Trap

This Post is based on something I wrote in 2015 and still holds true today…

A company is solvent when it has enough cash in the bank to pay bills as they come due. Banks (and other entities) that have loaned money to a company  periodically monitor the financial health of a business to ensure the business has sufficient cash flow to meet its debt obligations. Just because a business appears to be profitable does not guarantee its solvency. When a business does not have sufficient cash deposits or cash flow, or its level of debt to income is viewed as being too high, the bank may declare the company insolvent. Insolvency carries legal weight through a bankruptcy court and the company may be forced to cease its business operations and begin selling assets to pay off its debts.

The counterintuitive fact of insolvency is that even profitable companies may become insolvent. How can a company be profitable but not have the ability to pay its debts? Here is an example:

If company XYZ earns $200 a month and owes $150, it appears to be profitable. Let’s say the accounts receivable structure results in the receipt of $100 on the 5th of the month and $100 on the 20th of the month. If the company’s accounts payable of $150 is due on the 30th, there is no problem and XYZ is profitable and solvent. However, what happens if the $150 payment is due on the 15th of the month? XYZ has $100 but is insolvent (by $50) because it owes $150. XYZ can maintain solvency by getting a loan until it receives the next $100 payment five days later. The company repays the loan plus interest. XYZ’s profit for the month drops below $50 due to the interest payment. Maybe this means it can’t make rent or payroll obligations; maybe XYZ is ok for now.

Using the same example, what happens the next month if the money XYZ is supposed to receive on the 5th is delayed until after the 15th? In this case they owe $150 and will need an even bigger loan in order to remain solvent until XYZ receives the regular $100 payment on the 20th and hopefully also receives the past due amount in that time-frame as well. If the past-due money is not received, and the scheduled payment on the 20th is also delayed, things just became even worse. Now XYZ can’t repay the loan, can’t meet payroll or rent. XYZ also may not be able to order supplies or will order on “credit” which means they will owe even more money the following month. In the worst case scenario, XYZ’s lender decides the business is too risky, calls the loan due, takes the company to bankruptcy court and has the business effectively shut down.

Unfortunately this scenario happens frequently to businesses of all sizes.

Please understand the importance of cash flow and take the time to monitor it on a regular basis. Let me know if I can help review cash flow statements, income statements, balance sheets or any other financial reports. Depending on the complexity or severity of your situation, I may also suggest you work with a CPA (Certified Public Accountant) who can offer even more insight and help with your accounts payable and accounts receivable terms.