How “Liquidity” and “Capital” are not the same thing and why entrepreneurs need to know.
Just when our economy needs growth and new jobs to recover, businesses are faced with shrinking demand, diminished liquidity and the glass ceiling on their ability to borrow has crashed around their ears.
It would be short-sighted to blame all of small business’s “access to capital problems” on macro-economics. Regrettably, at least 80% of business owners mistake liquidity for capital. Both “Liquidity” and “Capital” are concepts measured in money but they come from different sources and serve different roles. While liquidity is required for daily survival capital is essential for staying power.
Liquidity
- Indicates probability that a company will have cash in the next 12 months to pay all expenses and obligations coming due in 12 months.
- “Probability” means business is inherently risky with no guaranties for entrepreneurs.
- Guesstimated by looking at cash, receivables, inventory versus payables, accruals, access to bank lines or credit cards and owner resources in the context of industry and individual business patterns.
Capital
- Comes from owner cash injections, outsider investment for part of the upside potential and funds from loans/leases with installment payments longer than one year.
- Comes from retaining some profits in the business (“Retained Earnings”). One of the most important sources of capital and one of the most violated.
- Properly used to support assets or strategic expenses that can directly create revenue over the long haul.
- Provides staying power when a business can repay/replace it through profitable operations year after year.
- Stabilizes cash flow by increasing the odds that liquidity will be sufficient year after year.
- Does not substitute for a weak business concept, inadequate sales, uncompetitive operations and poor management.
How We Got Here:
In the rah-rah period of easy credit lines, creative finance and competitive pressure lenders colluded with financial ignorance. Too many businesses funded capital needs – fixed assets for equipment and technology or strategic expenses for R&D, geographic and market expansion – or the wrong things with bank lines of credit and credit cards. This was bad finance the day it occurred. When their bankers declined loan requests, owners should have stopped to figure out why before taking matters into their own hands with easy money. Unsustainable business practices have led to unsustainable markets. Now these businesses are top heavy with both financial and business risk in an unforgiving economy. The central banking system will protect its own and so the brunt of the consequences will fall on small business.
The primary questions become: “Will our industry recover?” “Can we get sufficient market share to be profitable going forward?” “Do we have the cash to wait it out?”
This calls for honest, painful self-assessment. Companies with amateurish accounting practices need to invest in proper financial reporting. Accounting software and financial management are not the same thing. Unless you know the business is profitable, you can’t make the right decisions, you can’t convince potential financial partners to work with you and you don’t have a future. If the answers are “No”, access to capital is not the underlying cause of your current problems. Consider investing in professional advice on how to exit the market with the most marbles possible.
Solutions:
If the answers are “Yes” or “Maybe” then solve liquidity problems by getting your capital base back in line. This only works if you absolutely know how to run your business to earn a profit and convert it to cash consistently.
- Convert frozen credit line balances to the longest possible term loan. Fighting over the interest rate is not in your best interest…go for the longest payback period they will allow.
- Look for leasing companies that specialize in your type of equipment or assets and refinance what you own free and clear. Pay off short term, variable rate debt that favors the lender.
- Formalize with trade creditors for longer terms.
- Leave more profits in the business – even if it has potential tax consequences. Taking all the profits out of companies has robbed otherwise strong business of valuable long term capital, leaving them unprepared for economic downturn and shortening their life spans. Weigh the trade-off between paying a little more in taxes or losing the business.
- Figure out what it will take to turn a profit and use ingenuity in finding non-cash ways to get there. (Easier said than done.)
- Figure out how to become the most visible competitor in your market space and take market share now while competitors are floundering.
- Be careful about unknown alternative lenders/investors unless you can establish their integrity. Many business owners discover at the closing table the deal isn’t what they expected and partners they don’t want will have control of their businesses.
Visit out website at www.FinancialHolographix.com/Resources for some key words to use in searching for other solutions on-line.
