In their operations, companies may face an unpleasant situation where all financial reports show profit growth, but in reality, there is no cash. What should you do in such a situation? Let's break it down in this article.
This problem can arise in almost any organization, and some of the most common reasons include the following:
Accounts Receivable
You have a profit on paper, but the money from clients has not yet been credited to the accounts. This can be due to long payment terms under contracts or payment delays.
To address this, you need to control accounts receivable, accelerate payment collection, enforce strict payment terms for counterparties, or implement discounts for early payment.
Overvalued Inventory
The company may invest heavily in the purchase of goods, but these inventories do not turn into revenue. Inventory is reflected as an asset, which increases profit, but the money remains tied up.
Here, optimizing inventory management, accelerating the sale of surplus, and reviewing the procurement strategy can help.
High Operating Expenses
Sometimes, financial reports may show profit without accounting for significant current operating expenses, such as wages, rent, or marketing. As a result, these expenses exist in reality, but are not reflected in the report.
In this case, management accounting can help by adding any expenses the company incurs. Implementing management accounting makes the business more transparent, helps identify excessive operating expenses, and find ways to optimize them.
Investments and Capital Expenditures
A company may invest in equipment, real estate, or other assets, reducing the amount of available cash, although these investments are reflected in accounting profits.
Assess the necessity of investments and their impact on liquidity. You may need to reallocate funds or postpone major investments.
Inefficient Distribution of Dividends or Bonuses
If a company pays out too large dividends or bonuses, it can reduce available cash, even though profit remains on paper.
In this case, you may need to review your profit distribution and dividend policies.
Tax Liabilities and Debt Payments
A significant portion of the profit may go toward paying off taxes or loans. These obligations reduce liquidity, although profit may seem high in the reports.
Tax planning and a review of loan terms can help here. You might consider refinancing debts or changing your tax strategy.
Accounting Errors
Errors in financial accounting can result in reports showing profit that does not match the real situation.
Consider conducting an audit of financial statements, either on your own or with the help of specialists. This can help identify possible mistakes.
What Types of Businesses May Experience Liquidity Issues?
Primarily, these are companies in industries that require either large investments or have frequent accounts receivable from clients. The main segments include:
Manufacturing Companies
Such businesses often have large inventories of materials and finished products, especially during periods of rising raw material prices. Profit may be reflected in reports due to produced products, but the money remains "frozen" in inventory.
For example, manufacturers of household appliances or automobiles may invest heavily in raw materials and components but not see the return of money until the products are sold.
Companies with Long-Term Projects (Construction, IT, etc.)
These companies mainly sign long-term contracts, where revenue is recognized as work is completed, but actual payment may be received only at the project completion stage.
Wholesale Trading Companies
Their main problem is significant accounts receivable from clients. Until the debt is paid off, the money does not arrive.
For example, distributors may show a high volume of sales and profit, but not have free cash due to delayed payments.
Real Estate Management
A significant portion of the profit may be "frozen" in real estate, as the sale or leasing of properties does not always happen quickly. At the same time, profit can be reflected in reports as a result of asset growth.
Development companies may invest in building projects, but due to delays in sales or leasing, they may lack free cash.
Companies with Seasonal Business
During the high-sales season, profit may increase, but outside of the season, companies may not have enough cash reserves to cover operating expenses.
For example, companies selling winter gear may face cash shortages in the off-season, despite good profit figures in the winter.
Companies Actively Expanding
Investments in new markets, branches, or directions may consume cash, even as profit grows.
Restaurant chains or retail stores actively opening new locations may experience cash shortages, as much of their funds go into expansion.
Transportation and Logistics Companies
These companies often make large investments in equipment, infrastructure, or technology, which reduces the amount of available cash.
For example, transportation companies or logistics providers may earn profit from operations, but high capital expenses for fleets and warehouses can reduce free cash flow.
What to Do?
One key recommendation for improving business liquidity is to implement management accounting within the company. In management accounting, various expense and income items can be taken into account, allowing for multiple perspectives on data and comparisons between planned and actual results over a given period.
Automation can significantly help in implementing management accounting. Modern flexible systems allow the creation of multidimensional models based on the specific accounting rules adopted by the company.
