Difficult Times Illustrate Need for Sufficient Cash Reserves

Amidst the current recession, manufacturers commonly regarded as industry leaders are struggling to survive.

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Some may not make it. These are companies that once generated enviable income and expense statements. Their difficult position illustrates the importance of forecasting income and expenses, and monitoring cash reserves, rather than relying upon income and loss statements as primary indicators of future financial health.

Taken by itself, an income and loss statement is a historic report; it only tells managers how well a business fared during a defined past period. While forecasting utilizes historic data compiled for such statements, it focuses attention on the future. It prompts managers to anticipate changing economic conditions, rather than just react to such events as they occur. That awareness leads to timely assessments of whether or not the manufacturer has sufficient cash reserves to sustain itself through prolonged declines in sales revenues and/or profitability. The company then has time to mitigate the risk of not having sufficient liquidity.

Forecasts for income and expenses rely upon reviews of monthly company performance for 24-month spans. Such reviews reveal whether there have been slight or substantial increases or declines in either revenues or costs. Evaluations of month-by-month changes reveal trends or patterns that provide a basis for forming future expectations.

While illustrating such trends or patterns, forecasting also considers the underlying aspects that contribute to overall revenue and expense totals. What percentage of sales transactions are conducted with cash, as opposed to credit? For credit-based transactions, a manufacturer may regard 28 days as the standard duration for receiving payments. Within a recession, however, a span of 35 to 40 days may be a more realistic estimate. Cash flow forecasts need to incorporate such considerations.

Evaluations of past monthly expense totals require similar examination. Revised licensing agreements, rent for a new plant or other recently incurred obligations may make some past expense information obsolete. Periodic expenses for loan payments, taxes and other costs should also be considered.

The company also needs to address the impact of large, one-time capital outlays for equipment, a different facility, a new information technology system or other major costs. While such major costs are typically assigned to a capital budget, the company must evaluate whether anticipated income or reserves will be sufficient to fund that budget and those expenses. Monthly fluctuations in gross margin percentage typically indicate increases or declines in costs of sales. Those and other vital measures likewise merit attention when developing forecasts.

Adequate reserves

Once forecasts have been developed based on income, expenses and other critical metrics, they need to be reviewed monthly, and updated when needed to incorporate recent, monthly changes. With those forecasts, the manufacturer can then evaluate whether it has sufficient cash reserves.

While each company is unique, cash reserves should generally cover six months of fixed costs. That level of reserves buys time for reducing labor expenses and other variable costs, if needed.

If the manufacturer determines that its cash reserves may be insufficient, there are numerous steps it can take, including:
• Reviewing delinquent accounts and collection practices
• Hiring an attorney or collection agency to recover as much as possible from delinquent accounts
• Discussing credit concerns with a banker before additional credit is needed
• Postponing major purchase plans
• Analyzing product inventory turns
• Eliminating low-volume, low-margin products.

Addressing financial difficulties is a daunting task, but a company’s banker, lawyer, certified public accountant (CPA) and other professionals can provide vital help. In addition to offering specialized areas of knowledge, those individuals provide valuable perspective, based on their experiences in helping other organizations that faced similar circumstances.

With the help of those individuals, and by regularly forecasting and evaluating financial cash reserves, a manufacturer is better equipped to withstand current or future financial pressures and uncertainty.

Mark Walker, CPA, mdwalker@weaverandtidwell.com, is a Tax Partner for Weaver and Tidwell L.L.P.

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