A company must maintain sufficient cash resources to pay all legitimate bills as they arise. A company that cannot do so has run out of liquidity and is in a very serious financial condition.
Boards can make a tremendous contribution by focusing on one key question: Will liquidity be sufficient if condition sour? Adverse situations will come, whether caused by externalities like a recession or aggressive competition or by internal disappointments such as a failed mega acquisition that was made by incurring very high debt. The board can suggest that management consider what will happen to cash if thing don’t go as planned, particular if things turn negative simultaneously. It may difficult to raise additional funds, if crisis arises. What happens, then, if customers see your operational and financial difficulties and become hesitant to do business with you?
The primary tool for board to assess financial health is operating cash flow. The flow of cash through organization is sometimes compared with the flow of blood through the body. Cash is continuous circulation through the arteries of business carrying value to its various organs. If this flow stopped, or even severely reduced for a time, then serous consequences result.
When boards are evaluating major business units in a diversified company, the operating cash flow diagnostics often reveal which business units are consuming cash, for how long, and which one are generating cash. How good is this balance?
Financial health is indicated also by the capital structure of the company. What debt-to-equity ration is robust and appropriate for the kind of risks and rewards the company anticipate? Often, a decision is made about what kind of rating the company must maintain. For example, in GE’s case, management will do everything in its power to maintain its AAA credit rating.
Periodic discussion of the balance sheet can ensure that the appropriate capital structure is adhered to. Attention to the balance sheet ensure the management does not overstretch to make acquisition that promise fantastic revenue and earnings growth.
Boards should do a full analysis of the balance sheet once or twice a year to help management consider its strength under variety conditions, such as an earnings slump or a slowing economy. How will the balance sheet look under these circumstances? Should it be restructured now to prepare for the future?
Notes
Operating cash flow = operating profit + Depreciation
When we look at a company’s liquidity position we must make a distinction between long-term and short-term sections of the balance sheet.
Short-term liquidity measures Current ratio (CA/CL), Quick ratio (CA-Inventory)/CL), working capital to sale ratio (CA-CL/sales), working capital days.
Long-tem liquidity measures Interest cover (EBIT/Interest, Debt to equity ratio (D/E), Leverage
The greater the debt, the greater the risk. However, debt cost less than equity funds. By adding debt to its balance sheet, a company can generally improve its profitability, add to its share price, increase the wealth of its shareholders and develop greater potential growth.
Source:
1. Ram Charan, Boards that Deliver: Advancing Corporate Governance from Compliance to Competitive Advantage, John Wiley & sons, Inc., 2005
2. Ciaran Wash, Key Management Ratio, Pearson Education Limited, 2003
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