Why do profitable firms go bust? - MoneyWeek Investment Tutorials

it's an investor's worst nightmare you buy shares in a company that looks profitable and a few weeks months or even longer later it goes bust so how can that happen and what can you do about it well the key is an investor is obviously to spot it before it happens not much point in being smug after the event if you already bought shares in the Duff company and it's already gone must so the key is to look for warning signals now what could cause a company that's making money looking like it's generating profits to run out of cash and the answer is something called over trading there are actually several reasons why a company could go bust that way but it's called over trading and essentially it means you stop managing your working capital correctly if that sounds dull and a bit of a mouthful it's actually crucial many company directors are good at generating profits not so good at watching cash flow and working capital many investors are lured in by a profit loss account that looks juicy and they fail to spot that the company is running out of cash so in this video we're going to introduce the idea of profits leading to negative cash flow sounds a bit weird but I'll explain in a moment with an example we're going to look at how that happens and how you can spot it happening and hopefully take evasive action in time okay so I'm going to go straight in with a little example all right keep the numbers nice and simple all right and at the end I'll mention a couple of videos where you can get some more information okay so let's take a very simple profit and loss account for a company very simple so let's just say we have a company trading for one period now this could be a month or let's say a year because one period of trading and let's say on the back of an envelope we're not going to do a proper profit and also count in this video we have sales let's say of 100 million ok so sales are 100 million and I'm going to ignore for accountants out there any opening closing stock impact for those non accountants out there the assumption I'm about to make is that we only buy as much stock as we can sell before the end of the period there's no spare okay either the style the end so bear with me on that one let's say we have purchases because you can't sell something until you've bought something to sell if you said I mean so let's have purchases of 80 million marvelous this is a profitable firm over this period profits 20 million an accounting book call that a gross profit because it's before overhead costs all right we going to stop there I mean so that's good enough that's trading profitably we're buying stuff okay and then selling it on and we're making 20 million and the directors might say to you as an investor this is brilliant they might use lots of language to try and make you see how fantastic this is they might just say profits 20 million tada or they might say our margin is another way of impressing you as an investor is 20 percent for those who are calculation that's simply the profit figure over the sales figure times 100 percent to give it a percentage all right so our gross margin is 20 percent and that's pretty healthy put it on there's nothing wrong with that or our markup is what to do markup you simply take the profit figure over the cost of making your sales which is purchases in this case so 20 over 80 million as a percentage is 25% so however you cut this cake and the directors might try and impress you a few different ways looks good however this ignores trading terms all right this has nothing to do a cash flow I'm going to do some trading terms to show you how this can actually translate into a rather hideous cash flow picture this is a small business so let's assume number one the people it's selling to demand a lot of time to pay generous credit terms why because they can because they're bigger than us all right and the people we're buying from do the opposite they want paying quick very few of them are prepared to trust a small firm to pay them on time so let's put some credit terms in or I write everything up let's assume that three quarters of our sales have to be on credit we have to offer credit so we're not getting paid yet and let's assume that we're not paid in this accounting period say first month of trading all right and let's also assume that the opposite is true for perched is so we have to pay for our perch is 3/4 of the in cash we can only get if you like credit for a quarter of our purchase let's see what that does to cash flow as cash in and out not booking sales when the stuff leaves the front door okay when the invoice is issued but actual hard cash in the same period so let's introduce that and see what our cash flow now now looks like alright now remember what I said we said three quarters of our customers demand credit so cash in is well that's alright but cash in is only going to be twenty five million all right that means a quarter of our customers have paid us but at um here at the end of the accounting period right and then we said but the opposite problem with purchases we've actually got to pay for three quarters of these okay by the time we hit the end of our accounting period so this is a little cash flow statement running next door 25 millions come in as a quarter of our sales but sadly yet three quarters about sixty million about eighty million so has gone out to pay our suppliers alright and that doesn't look quite so good okay over the same accounting period with May over twenty million profit but 25 million of cash coming in sixty million of cash going out leaves us 35 million down in pure cash flow terms and that's not good alright so bit of a problem if this is a cash flow statement we've actually which probably means we're heading into overdraft or haven't you approach to Bank we're going to going to our borrowing or go back to our lenders and say how we're going to do this all right and if this continues alright we could actually go bust quite quickly the banks like it fed up and say we think very well make you money Tim but where's the cash all right we're getting nervous so you can see I'm very very simple example how business can be rocketing away making lots and lots of sales but its credit terms with its customers and suppliers mean it's losing cash right now you might say okay how can I spot this happening all right well the cash flow statement is one option all right but some people are not very comfortable cash flow statements it takes them long enough to get to grips with profit loss account so they don't to go digging around in the cash flow statement B you could and you see this time to happen another place you can go is what's called working capital section of the balance sheet a very quick way to spot a company it's over trading in other words making profits not generating cash flow from them is to take a quick look at what's called working capital here's another way to cut the cake all right what you won't get from a company and that's why I haven't written it up is its credit terms right most directors won't give you that information it's commercially sensitive they're not going to normally say in the accounts or at a public meeting all by the way three-quarters of our suppliers demand cash and the rest we get credit from that's not the kind of information is normally available but on a balance sheet you can do a very quick way of looking at this and deciding probably there is a problem all right so that will come up in the cash flow statement fine but what about the balance sheet well here's another way to look at it if we sold 100 million during our first trading period right a month to proc imma save quite a big company all right and we've got a quarter of that in as cash that means we're out presumably seventy-five million and by somebody it's when we stopped the clock and draw up a balance sheet presumably we have the receivables as the Americans would say what debtors the British would say of well it must be 75 million all right somebody out there owes our 75 million cool receivables and it's an asset all right if your mate owes you 10 pound because you lent him 10 pound down the pub last night assuming he's still around to collect it from that's an asset until he pays you that's the way accountants think right money do to come in it's good news money do you to go out I'm afraid is bad news it's called a liability all right you know that if you've got a bill coming up the oven get paid for electricity or something okay you've got to pay it sooner or later so basically you could look at this and say well we made 80 million of purchases okay we paid for 60 million and therefore there's presumably 20 million left to go right now just to introduce another bit of jargon accountants and other people and analysts quite like the difference between the 75 that were owed and the 20 million we've got to pay is 55 million and that in my simple example is known as working capital all right you can pick up a balance sheet you have a quick look at look at it you can pick up the receivables figure the payables figure amounts to you within one year you can add in any stock balances you can add in any cash you get to make a working capital I've just done two lines all right now a lot of people would say working capital that is literally the capital working to generate our trading profits if you like okay locked up in receivables payables stock and so on is good news sort of all right problem with a lot of working capital the problem of all the working capital is it indicates that the business is not collecting cash efficiently it's not managing its cash efficiently and if you see working capital studies rise quickly which means receivables going up okay maybe payables going down and the business is not taking full advantage of the trading terms it cooked because if you think about it basically you don't want to offer customers a lot of credit ideally on arraign these customers it get them to pay quicker commercially you may have to offer them credit but it's not good for a small business to have to do that alright so on the supplier side they deal E as a small firm we'd be taking credit from our suppliers for as long as possible so if you see supply of balances shrinking away yet the business is still growing you've got to think what are they doing okay this is this is indicative of a future cash flow crisis how they going to manage that where's the funding all right so working capital increasing rapidly okay in a growing business that's going fast can indicate cashflow trouble and they Vantage of looking at floating capital on the balance sheet is it gives you more information you know just saying well cash 35 million negative we need to start to know why okay I'm working capital analysis if you like starts to tell you why so I'll tell you where it's gone how the directors could rein it in alright so just going to suggest in this video today but small firms especially in the current environment can go bust quite easily all right one of the reasons they do is they lose control of working capital it's a concept that many investors and directors don't fully understand alright so they're surprised when it happens working capital is simply a consequence of credit terms largely and the need to build up capital to trade okay as a small business or even as a medium or large business so before a business goes over the cliff all right I'll advise you as an investor to say great they got some profits what's happening to cash flow and how are they managing working capital nothing else it's a good question to turn up let's say an Android general meeting of shareholders and put to the directors do you understand where the cash is going

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Keywords: Working, capital, Cash, flow, Overtrading, market, firms, bust, red, profit, loss, Share, trading, How, shares, traded, Liquidity, Bid, to, offer, spreads, rate, MoneyWeek, Investment, Tutorial, Currency, Central, bank, finance, credit, 'stock, market', investments, tutorials, Trading, Stocks, Analysis, Trade, Tim, Bennett, Economy, whiteboard, white, board, explained, Educational, economy, Business, Forex, Financial, Technical, Bloomberg

Id: d0FY4xRT_yo

Length: 11min 22sec (682 seconds)

Published: Fri Jan 27 2012