FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1

Print pagePDF pageEmail page

Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of www.BusinessThinker.com

Most employees, the media, and even entrepreneurs measure success by sales and sales growth. Most “lists” like INC 500 and FORTUNE 500 rank companies this way. In earlier articles we discussed pitfalls of this approach. But if banners and plaques are not a good measure of success, what is? Seasoned business owners realize that profits and asset growth provide better assurance of a firm’s long term survival and ability to thrive. Liquidity, or the availability of cash, is also a hallmark of the well-run business.1

ASSESSING YOUR FINANCIAL VIABILITY
What does financial viability mean? How well does your company stack up? By taking a few minutes to answer the following questions, you get a quick feel for this issue.

I. Liquidity and cash flow:
Question 1. Liquidity. How would you describe your current cash position (cash in the bank, whether obtained by a bank loan, retained earnings, or from start-up capital):
[1] Significant liquidity, available for major investment–e.g., a new plant, building, large piece of equipment
[2] Some liquidity, available for minor investment–a new truck, smaller piece of equipment, office equipment
[3] Little liquidity, available only for high priority items to keep current operations going
[4] Very little liquidity– difficult to cover even essential items to keep current operations going
The median firm in our study reported “some” liquidity ([2] above). Yet 45 percent report having “significant” liquidity.
Question 2. Has your level of liquidity hampered business operations any time during your firm’s growth? If yes, in what way?
Question 3. Was there any particular reason that your cash position has been unusually good or poor in the past few years–purchase of a building or a large drop in sales or profitability for instance?
II. Profitability
Question 4. Subjective rating of profits. What has your profit picture been like for each of the past five years? Rate your firm for each year separately:

[1] Very profitable
[2] Fairly profitable
[3] Somewhat profitable
[4] Break even
[5] Somewhat unprofitable
[6] Fairly unprofitable
[7] Very unprofitable
At the time of the study, the median firm reported being “somewhat” profitable ([3] above). About one in five CEOs reported being “very” profitable ([1]).
Question 5: Percentage net profit. Do you track your net profit, that is, your rate of return on gross revenues, on a regular basis?
Only about 70 percent of the CEOs we interviewed track their net profit closely. When we asked the following question, some CEOs had memorized their numbers but others needed to dig through the files to determine whether or not they were even profitable.
Question 6: Percentage estimate of return on sales (ROS): What would you estimate your net profit (pretax) as being, in percentage terms (that is, dollars of net income divided by total annual revenues), for each of the past five years?
In the fiscal year during which the study took place, the median net profit of firms under study was about 2 percent, the average net profit being about 4 percent. Profits ranged between an 18 percent loss and a 35 percent gain.

WHAT WE MEAN BY FINANCIAL VIABILITY
An organization that is financially viable can pay its bills when due and operates at a profit.2
Short-Term Profits: Why We Use it To Measure Financial Viability
When companies such as General Motors was losing billions of dollars a year and yet you could still see plenty of Oldsmobiles and Buicks cranking off the assembly line, it gave many people the impression that short term profit and loss are not all that important. But large companies are usually very different from most small to medium sized firms in a fundamental way–they have accumulated huge assets from previous years of profitability– assets that include investor confidence in their ability to survive to another upturn. Some small companies are asset-rich enough that they can also survive severe periods of unprofitability. These are usually older firms that have socked assets away in a manner that is reasonably liquid. Among rapidly growing firms it is less common, since much capital is absorbed in fueling growth. Although short-term profits may have their pitfalls, they still provide a reasonable snapshot of a small firm’s financial health–good enough for our purposes.
We do caution against putting exclusive emphasis on
Short term profits. Capital investments that may be required in long-term growth will suppress a firm’s profit and cash position even though the long run effects may be positive. On the other hand, they need to be done judiciously or else long term profitability will also suffer. 3
Cash Flow: Another Important Aspect of Financial Viability
One overlooked financial measure is the flow of cash, as distinct from paper profits. Many books and seminars have been dedicated to the problems and solutions for managing cash flow effectively.4 Though related to profitability, cash flow is not guaranteed just because a firm is profitable. For instance, a firm may be cash poor but profitable when it has tied up too much of its capital in inventory buildings and expensive equipment. Rapidly growing firms are almost by definition in cash-poor situations, because more money is needed to produce the products or services than was realized by previous sales. Absolute limits on internally financed growth can be calculated this way. Taking out short-term loans, including renegotiating better creditor terms, stretches these limits. However, prolonged use of such techniques often increases risks. The riskiest technique of all is to refinance growth via deferral of withholding taxes. Yet many owners have to admit they’ve done it, unwise as it is.

Because of the critical importance of being able to pay one’s bills, the cash flow indicator is examined in parallel with profitability as an indicator of financial viability throughout this article.

2 thoughts on “FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1”

  1. Dr. John – this is a good article. I will be interested in seeing future articles on how to improve cash flow as I think this is the best measure of financial viabibilty..

  2. Dr. John – this is a good article. I will be interested in seeing future articles on how to improve cash flow as I think this is the best measure of financial viabibilty..

Leave a Reply

Your email address will not be published. Required fields are marked *