Warren Buffett: The 4 Balance Sheet Red Flags That Predict Bankruptcy

 

Warren Buffett's Guide to Spotting Bankruptcy: The 4 Balance Sheet Red Flags

For any investor, avoiding catastrophic losses is just as important as finding winners. In this talk, Warren Buffett distills seven decades of experience into four simple, powerful balance sheet red flags that predict financial distress with remarkable accuracy. Ignoring these signs once cost him $358 million on a US Air investment. Here’s how you can protect your capital.

The Core Philosophy: The Balance Sheet Never Lies

Most investors focus on the income statement—revenue and earnings growth. But that’s the rearview mirror. The balance sheet is your windshield; it shows whether a company has the financial strength to survive the road ahead. Revenue can be manipulated, but cash, debt, and working capital reveal the unvarnished truth.

The 4 Red Flags That Predict Bankruptcy

1. Excessive Debt Relative to Equity

• What it is: A dangerously high debt-to-equity ratio. Debt creates mandatory payments; equity provides flexibility.

• Why it’s fatal: In a downturn, debt payments become a noose. Creditors can force bankruptcy if payments are missed.

• The Lesson from Lehman Brothers: In 2007, Lehman had a debt-to-equity ratio of 30-to-1. When its assets lost just 3.3% of their value, shareholder equity was wiped out. This massive leverage made its collapse inevitable.

• Your Action: Calculate Total Debt / Total Equity. For most companies, a ratio above 2-3 is dangerous. Watch the trend—if it’s rising, risk is increasing.

2. Declining Cash & Ballooning Receivables

• What it is: Cash is falling while accounts receivable (money owed by customers) is rising much faster than sales.

• Why it’s fatal: It signals customers aren’t paying, or the company is offering desperate credit terms to book fake revenue. This creates an illusion of growth while the company runs out of real money.

• The Lesson from a 1990s Tech Firm: It reported 20% growth, but cash halved while receivables soared 150%. The "revenue" was uncollectable, and the stock crashed.

• Your Action: Calculate Days Sales Outstanding (DSO). A DSO rising above 90-120 days is a major red flag. Monitor the cash conversion cycle.

3. Declining Tangible Assets / Inflated Intangibles

• What it is: A balance sheet loaded with goodwill and intangible assets but lacking tangible assets (cash, inventory, property) that hold real value in a crisis.

• Why it’s fatal: Goodwill is worth $0 in bankruptcy. It’s an accounting entry for overpayment on past acquisitions. A company with negative tangible equity has no real asset cushion.

• The Lesson from General Electric: GE accumulated $75B in goodwill. When stripped away, its tangible equity was negative. The eventual write-offs devastated the stock.

• Your Action: Calculate Tangible Equity (Total Equity - Intangibles). If it’s low or negative, the company’s financial strength is an illusion.

4. Inadequate Working Capital

• What it is: Current liabilities exceed current assets (a current ratio below 1.0), meaning the company can’t cover bills due within a year.

• Why it’s fatal: It leaves no margin for error. Any disruption—a sales miss, a delayed payment—can cause immediate insolvency.

• The Lesson from Toys "R" Us: Before its 2017 bankruptcy, its current ratio was 0.73. It was dependent on perfect holiday sales and collapsed when they disappointed.

• Your Action: Calculate the Current Ratio and the more conservative Quick Ratio (excludes inventory). Understand why it’s low: Is it from efficiency (like Amazon) or from distress (high debt, no cash)?

The Ultimate Warning: Multiple Red Flags

A single flag can be a warning, but multiple flags are a death sentence. Sears Holdings is the classic example. Years before its 2018 bankruptcy, it exhibited all four: soaring debt, vanishing cash, negative tangible equity, and crippled working capital. The balance sheet told the entire story years in advance.

The Buffett Playbook: How to Act on This Knowledge

1. For Current Holdings: If a company you own shows these signs, sell immediately. Do not hope for a turnaround. "Take your loss and move on."

2. For New Investments: Screen the balance sheet first, before looking at the growth story. If red flags appear, walk away. There are thousands of stocks; avoid the financially distressed.

3. For Business Owners: Use these principles to build a "fortress balance sheet" for your own company. Prioritize survival over aggressive growth.

The Investor's Mindset

• Seek Simplicity: These four rules are simple but have proven effective across decades and industries.

• Prioritize Safety: The best managers are obsessed with balance sheet strength. They know survival comes first, growth second. Look for companies with minimal debt, ample cash, and strong working capital—they sleep well at night and emerge stronger from crises.

• Trust Reality: "Cash is cash. Debt is debt. Working capital is working capital." These numbers reflect reality. Learning to read them will put you ahead of 90% of investors.

Final Takeaway: You don't need to predict the future. You just need to read the present accurately on the balance sheet. This discipline will help you avoid catastrophic losses and build lasting wealth by investing in companies built to last.

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Based on the transcript provided, here is a summary of the content from 0 to 10 minutes:

Key Point: Warren Buffett introduces a personal, costly lesson about ignoring balance sheet warning signs, leading to a $358 million loss from a 1989 investment in US Air.

The Story:

• In 1989, US Air approached Buffett seeking a $358 million investment. On the surface, the airline industry was recovering and the company looked fine.

• Despite seeing four specific red flags on the balance sheet that made him "deeply uncomfortable"—concerning debt levels, weak cash position, unsupported tangible assets, and fragile working capital—Buffett invested anyway.

• He ignored his gut and analysis because he liked the management, thought the preferred stock terms protected him, and believed an industry turnaround would fix the problems.

• This was a major mistake. US Air struggled for years, the balance sheet issues persisted, and Buffett had to write down a significant portion of the investment.

The Core Lesson:

• "The balance sheet never lies." It reveals whether a company is heading for bankruptcy, but only if you know what to look for and have the discipline to act on it.

• Buffett contrasts the balance sheet with the income statement:

  • The income statement is a rearview mirror—a historical snapshot of past profitability that can be manipulated.

  • The balance sheet tells you about the future—it shows a company's financial strength and its ability to survive hard times, pay debts, and invest. Its numbers (cash, debt, assets) are much harder to fake.

• He credits his mentor, Benjamin Graham, for teaching him to see the balance sheet as a "financial X-ray" that can spot trouble long before it becomes obvious. The goal is to find a "margin of safety"—companies with strong balance sheets can survive shocks, while weak ones collapse at the first sign of trouble.

Transition: Buffett promises to share the four balance sheet red flags that predict bankruptcy with remarkable accuracy, patterns he has observed over seven decades in major failures like Enron and Lehman Brothers.

Here is a summary of Warren Buffett's explanation from approximately 10 to 20 minutes, covering Red Flags #1 and #2:

Red Flag #1: Excessive Debt Relative to Equity

• The Core Idea: This is the single best predictor of bankruptcy. Debt creates mandatory payments that must be made regardless of business conditions, while equity (ownership) provides flexibility. A high debt-to-equity ratio means a company has no financial cushion.

• The Danger: A company with high debt is "one bad quarter away from disaster." If business slows, it cannot service its debt, creditors can force liquidation, and equity can be wiped out.

• Case Study - Lehman Brothers (2008):

  • In 2007, Lehman had $680 billion in assets but $613 billion in debt and only about $22 billion in equity.

  • This created a debt-to-equity ratio of nearly 30-to-1, meaning if their assets lost just 3.3% of their value, shareholder equity would be completely erased.

  • When the housing market declined and their mortgage-backed assets lost value, this exact scenario played out, leading to the largest bankruptcy in U.S. history.

• How to Use This:

  • Calculate the ratio: Total Debt / Total Equity.

  • For most non-financial companies, a ratio above 2 or 3 is dangerous. Above 5 is "walking a tightrope."

  • Look at the trend. An increasing ratio is a warning sign of growing risk.

Red Flag #2: Declining Cash & Ballooning Receivables

• The Core Idea: When cash is falling while accounts receivable (money owed by customers) is rising much faster than sales, it's a major red flag.

• What It Signals:

  1. Customers aren't paying their bills.

  2. The company is offering overly generous payment terms (e.g., 90 days instead of 30) just to make sales and hit revenue targets.

• The Reality: This creates the illusion of growth on the income statement, but the company isn't collecting real money. You can't pay bills with receivables.

• Case Study - A 1990s Tech Manufacturer:

  • Reported fantastic 20% annual revenue growth.

  • But over two years, cash halved (from $100M to $50M) while receivables soared 150% (from $80M to $200M) on only 40% sales growth.

  • This disconnect revealed they were booking fake revenue from customers who couldn't pay. The company eventually collapsed.

• How to Use This:

  • Calculate Days Sales Outstanding (DSO): (Accounts Receivable / Annual Revenue) x 365.

  • A DSO rising above 90-120 days is a red flag.

  • Monitor the cash conversion cycle; if it's increasing, the company is tying up more capital in operations and running low on cash.

Conclusion of this segment: These first two flags—runaway debt and a deteriorating cash collection cycle—are powerful early warnings that a company's financial health is in serious decline.

Here is a summary of Warren Buffett's explanation from approximately 20 to 30 minutes, covering Red Flag #3 and introducing Red Flag #4:

Red Flag #3: Declining Tangible Assets / Inflated Intangibles

• The Core Idea: A buildup of intangible assets (like goodwill, patents, brand value) that don't have real, realizable economic value is a major warning sign. In a crisis, you can't sell them to raise cash.

• The Critical Problem - Goodwill: This is an accounting entry representing the premium paid for acquisitions. In bankruptcy, goodwill is worth $0. A balance sheet loaded with goodwill can look strong on paper but be hollow in reality.

• Case Study - General Electric:

  • GE grew for decades through acquisitions, accumulating about $75 billion in goodwill on its balance sheet by 2017.

  • However, its tangible equity (real net worth after subtracting intangibles and liabilities) was actually negative.

  • When business struggled, GE had to write off billions in goodwill, admitting the acquisitions didn't create the promised value. The stock collapsed.

• How to Use This:

  • Calculate Tangible Equity: Total Equity - Intangible Assets.

  • If tangible equity is low or negative, the company lacks real financial strength and is vulnerable.

  • Watch the trend: If intangibles are growing faster than tangible assets, management may be focused on risky "empire building" through overpriced acquisitions rather than creating real value.

Red Flag #4: Inadequate Working Capital

• The Core Idea: Working capital (Current Assets - Current Liabilities) is the lifeblood for day-to-day operations. If a company doesn't have enough liquid assets to cover bills due within a year, it can't survive disruptions.

• The Key Metric - Current Ratio: Current Assets / Current Liabilities. A ratio below 1.0 is a danger zone, meaning short-term debts exceed liquid assets.

• Case Study - Toys "R" Us (2017):

  • The year before bankruptcy, its current ratio was 0.73 ($2.2B in current assets vs. $3B in current liabilities).

  • It was dependent on perfect holiday sales to generate cash. When sales disappointed, it had no cushion and filed for bankruptcy.

• Important Distinction: Some strong companies (like Amazon) operate with low working capital due to efficiency and market power (collecting cash fast, paying suppliers slow). The red flag is when it's due to distress—high short-term debt and minimal cash.

• How to Use This:

  • Calculate the Current Ratio and the more conservative Quick Ratio (which excludes less-liquid inventory).

  • Look at the trend and components. Is the low ratio due to rising debt and falling cash? That's the warning.

  • Check if the company generates enough cash from operations to fund its working capital needs.

Transition: Buffett notes that a single red flag can be manageable, but when multiple flags appear together (e.g., high debt, falling cash, inflated intangibles, and poor working capital), bankruptcy becomes highly probable, as seen in the case of Sears Holdings.

Here is a summary of Warren Buffett's explanation from approximately 30 to 40 minutes, covering the conclusion and practical application of the four red flags:

The Danger of Multiple Red Flags

Buffett emphasizes that the most dangerous situation is when all four red flags appear simultaneously in a company.

• Case Study - Sears Holdings: By 2010, Sears showed concerning debt levels. Over the following years, the pattern worsened: cash declined, tangible equity turned negative as they sold off real estate, and working capital deteriorated until vendors demanded cash on delivery.

• The Result: All four red flags were waving years in advance. The 2018 bankruptcy was "inevitable" for anyone reading the balance sheet accurately.

How to Use This Information Practically

Buffett provides clear, actionable advice for investors and business managers:

1. If You Own the Stock: If a company you own shows these red flags, sell immediately. Don't hold on hoping for a turnaround. "Listen, sell before the bankruptcy. Take your loss and move on."

2. If You Are Considering Investing: Check for these red flags first, before looking at the income statement or growth story. If you see them, walk away. "There are thousands of stocks to choose from. Why invest in one that's showing signs of financial distress?"

3. If You Run a Business: Use these principles to prevent trouble in your own company. Monitor debt, cash flow, and working capital. Avoid overpaying for acquisitions that create hollow goodwill.

The Buffett Philosophy: Simplicity and Safety

• Simplicity Works: Some may argue finance is more complex, but Buffett states these four simple flags have been reliable predictors across decades and industries.

• The Managerial Mindset: Companies that fail are often run by managers focused on growth, deals, and income statements, not balance sheet strength. The best managers are "obsessed with balance sheet strength" because survival comes first, growth second.

• Berkshire's "Fortress" Approach: At his own company, Buffett maintains a "fortress balance sheet" with minimal debt and lots of cash. This conservative approach allows them to sleep well and be ready to seize opportunities during crises.

Final Takeaway

Buffett's core closing message is: "The balance sheet never lies."

• Revenue and earnings can be manipulated, but cash is cash, and debt is debt.

• Learning to read these signs will put you "ahead of 90% of investors," allowing you to avoid failing companies and identify strong ones.

• The discipline to act on these four red flags—excessive debt, declining cash with rising receivables, inflated intangibles, and inadequate working capital—has saved him from disaster and will serve any disciplined investor or business leader.

Here is a summary of the content from 40 minutes to the end (53 minutes):

Key Clarification on Working Capital

Buffett acknowledges that some strong companies (like Amazon and Walmart) can operate with low or negative working capital as a sign of efficiency and market power—they collect cash quickly from customers and pay suppliers slowly. The red flag is when negative working capital stems from financial distress: high short-term debt and minimal cash, as seen with Toys "R" Us. The key is to analyze the components and trend.

The Ultimate Danger: Multiple Red Flags

The most dangerous situation is when all four red flags appear together. Buffett provides a detailed case study of Sears Holdings:

• Excessive Debt: Debt-to-equity was concerning and kept increasing.

• Declining Cash: Cash reserves fell steadily from over $1 billion to a few hundred million.

• Inflated Intangibles / Negative Tangible Equity: Had billions in goodwill; by 2017, tangible equity was negative.

• Inadequate Working Capital: Current liabilities exceeded assets; vendors demanded cash on delivery.
  All four flags were waving years in advance, making the 2018 bankruptcy inevitable for observant investors.

Practical Action Steps

1. If you own the stock: Sell immediately when you see these red flags. "Take your loss and move on. Don't ride it all the way to zero."

2. If you are considering investing: Check the balance sheet and these ratios first. If red flags appear, walk away. "Why invest in one that's showing signs of financial distress?"

3. If you run a business: Use these principles preventatively. Don't let debt, cash flow, or working capital deteriorate.

The Philosophy of Simplicity and Safety

• While finance is complex, these four simple red flags have been reliable predictors for decades across industries.

• The best managers are obsessed with balance sheet strength. They prioritize survival over growth, ensuring they have a "fortress balance sheet" (like Berkshire Hathaway's) to weather any storm and seize opportunities.

• Failing companies are often run by managers focused on growth stories and income statements, ignoring the harsh reality of the balance sheet until it's too late.

Final, Powerful Conclusion

• "The balance sheet never lies." Revenue and earnings can be manipulated, but cash, debt, and working capital reflect reality.

• Learning to read these four signs will put you ahead of 90% of investors, allowing you to avoid bankruptcies and identify strong businesses.

• The discipline to act on excessive debt, declining cash with rising receivables, inflated intangibles, and inadequate working capital has saved Buffett from disaster and will guide anyone to safer, smarter investing. "The balance sheet is telling you everything you need to know. You just have to listen."

Bed Bath & Beyond shares plummet after company warns of potential bankruptcy

Bed Bath & Beyond shares plummet after company warns of potential bankruptcy

PUBLISHED THU, JAN 5 

KEY POINTS

• Bed Bath & Beyond warned Thursday it’s running out of cash and is considering bankruptcy.
• The embattled home goods retailer is having trouble getting enough merchandise to fill its shelves and is drawing fewer customers to its stores and website.
• It anticipates a net loss of about $385.8 million for the third quarter, a nearly 40% jump in losses year over year.

In this article, Bed Bath & Beyond warned Thursday it’s running out of cash and is considering bankruptcy.

The retailer, citing worse-than-expected sales, issued a “going concern” warning that in the upcoming months it likely will not have the cash to cover expenses, such as lease agreements or payments to suppliers. Bed Bath said it is exploring financial options, such as restructuring, seeking additional capital or selling assets, in addition to a potential bankruptcy.

Shares of the company fell about 30% to close the day at $1.69 after Bed Bath issued the updates in a pair of financial filings. The stock earlier touched a 52-week low earlier in the day. Its market value has fallen to about $149 million as of Thursday’s close.

Still, CEO Sue Gove said the retailer is focused on rebuilding the business and making sure its brands, Bed Bath & Beyond, Buybuy Baby and Harmon, “remain destinations of choice for customers well into the future.”

Among its challenges, Bed Bath said it is having trouble getting enough merchandise to fill its shelves and is drawing fewer customers to its stores and website.

The retailer also said it wasn’t able to refinance a portion of its debt, less than a month after notifying investors it planned to borrow more in order to pay off chunks of existing obligations.

Bed Bath’s debt load has been weighing on the company. The retailer has nearly $1.2 billion in unsecured notes, which have maturity dates spread across 2024, 2034 and 2044. In recent quarters, Bed Bath has warned it’s been quickly burning through cash.

Bed Bath’s notes have all been trading below par, a sign of financial distress. 

Stalled turnaround

Bed Bath has been through an especially tumultuous stretch, with the departure of its CEO and other top executives, companywide layoffs, store closures and an overhaul of its merchandise strategy. As sales declined, its CEO Mark Tritton got pushed out in June. Gove, who stepped in as interim CEO, has assumed the role permanently.

She laid out a comeback strategy in late August. As part of the plan, she said the company would cut costs by shrinking its store footprint and workforce. Gove said it would add back more items from popular national brands, as it shifted away from an aggressive private label strategy. And she said it had secured more than $500 million in new financing to help steady the business.

The company said during its last earnings report it believed it had enough liquidity to forge ahead.

In a news release Thursday, Gove said recent sales results illustrate why that turnaround plan is so important.

“Transforming an organization of our size and scale requires time, and we anticipate that each coming quarter will build on our progress,” she said.

The company is also looking for a chief financial officer after executive Gustavo Arnal died by suicide in September.

Mounting losses

So far, Bed Bath has not seen its sales trends change. Net sales in the fiscal third quarter, which ended Nov. 26, are expected to be about $1.26 billion — a sharp drop from $1.88 billion in the year-ago period, the company said.

It anticipates a net loss of about $385.8 million for the third quarter, a nearly 40% jump in losses year over year. The quarterly losses include an approximately $100 million impairment charge, which was not specified.

The company is scheduled to deliver full quarterly results and hold an earnings call on Tuesday.

Signs of Bed Bath’s financial stress have shown up on store shelves, too. As the retailer’s cash hoards dwindle, some suppliers aren’t willing to ship large quantities of merchandise — or in some cases, any merchandise — to the company.

Gove said in a news release that reduced credit limits mean customers are seeing emptier shelves and less variety than they expect. She said the company is using the money it’s made over the holiday season to pay vendors and order more inventory.

“We have seen trends improve when in-stock levels have increased,” she said.

Bed Bath already has a history of strained relationships with key national brands, such as Dyson, Keurig and Cuisinart. During previous holiday seasons, Bed Bath didn’t have popular gift items, such as KitchenAid’s stand mixers. Meanwhile, those items were plentiful at competitors like Target.

https://www.cnbc.com/2023/01/05/bed-bath-beyond-shares-plummet-as-company-warns-of-deeper-financial-troubles.html  (video link)

Glossary:  

Bankruptcy—a legal state wherein a debtor (borrower) is temporarily protected from creditors (lenders); under Chapter 11 of the federal bankruptcy code, companies may continue to operate 

Chapter 11—a section of the federal bankruptcy code whereby a debtor is reorganized as a going concern rather than liquidated (see bankruptcy) 

Commercial paper—short-term loans from institutional investors to businesses 

Default—the status of a company that fails to make an interest or principal payment on a debt security on the required date 

Exchange offer—an offer made by a company to its security holders to exchange new, less-onerous securities for those outstanding 

Financial distress—the condition of a business experiencing a shortfall of cash to meet operating needs and scheduled debt-service requirements 

Hold-up value— benefits accruing to participants in a class of securities who are able to extract considerable nuisance value from the holders of other classes of securities 

Par—the face amount of a bond; the contractual amount of the bondholder’s claim 

Recapitalization—financial restructuring of a company whereby the company borrows against its assets and distributes the proceeds to shareholders 

Secured debt—debt backed by a security interest in specific assets 

Senior-debt security—security with the highest priority in the hierarchy of a company’s capital structure 

Shareholder’s (owner’s) equity—the residual after liabilities are subtracted from assets 

Subordinated-debt security - security with a secondary priority in the hierarchy of a company’s capital structure 

Working capital—current assets minus current liabilities 

Understanding financially distressed and bankrupt companies.

Financially distressed and bankrupt securities are analytically complex and often illiquid.

The reorganization process is both tedious and highly uncertain. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity. 

In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, 

• - the effect of financial distress on business results; 
• - the availability of cash to meet upcoming debt-service requirements; and 
• - likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 

Similarly, investors in bankrupt securities must develop a thorough understanding of the 

• -  reorganization process in general as well as 
• -  the specifics of each situation being analyzed.

Financially Distressed and Bankrupt Businesses

Companies get into financial trouble for at least one of three reasons: 

• - operating problems, 
• - legal problems, and/or 
• - financial problems. 

A serious business deterioration can cause continuing operating losses and ultimately financial distress.

Unusually severe legal problems caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. 

Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.

Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations. 

• -  When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
• -  Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor’s woes. 
• -  Customers dependent on an ongoing business relationship may stop buying. 
• -  Employees may abandon ship for more secure or less stressful jobs.

Effect of financial distress vary from company to company

Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities. 

The operations of 

• capital-intensive businesses are, over the long run, relatively immune from financial distress, while 
• those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 

For some businesses the decline in operating results is limited to the period of financial distress. 

• -  After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. 
• -  Others, however, remain shadows of their former selves.  

The capital structure of a business also affects the degree to which operations are impacted by financial distress. 

• -  For debtors with most or all of their obligations at a holding company one or more levels removed from the company’s primary assets, the impact of financial distress can be minimal. Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
• -  Companies that incur debt at the operating-subsidiary level may face greater dislocations.

More often bankrupt enterprise continues in business under protection for some to return to financial health

The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate. Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 

Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 

• -  As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
• - Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
• -  As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
• - Cash usually starts to build (for a number of reasons). 
• -  When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 

While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.

Cashflow and monthly operating costs are key

Wed, 8 Apr 2020

AFTER watching Prime Minister Tan Sri Muhyiddin Yassin’s announcement on the enhanced stimulus package for SMEs, my various chat groups came alive with all kinds of comments and opinions. In particular, one chat group which comprises experienced retired senior bankers, entrepreneurs and senior business journalists (all about the same age of 60 and above) stood out for its wisdom and sharp foresight.

When asked about potential SME casualties in this economic crisis, a senior banker commented, “TH... I went through four deep recessions/business cycles, ie, 1987,1997,2007/8, and now 2019/20. Same like you, and no wiser than my friends in this group.

"My gut feeling is that there will be more casualties this time around because the pandemic is world-wide. But like all recessions, the economy will turn around. It will not likely be a V-shaped recovery. We all have to tighten our belts, cut losses, and make sure we survive to enjoy the recovery.”

He is correct, as this recession is like no other. It is the first time that almost all economic activities have stopped in all the major countries in the world at the same time. There is a supply shock as the supply chain has been completely disrupted to a standstill.

There is demand shock as sales of most industries have fallen off the cliff to almost zero during lockdowns, and there is capital market shock as global stock markets crash.

Predicting the timing of the recovery is extremely difficult as we now have to deal with a virus pandemic with no solution in sight. Yes, a complete lockdown can flatten the curve but the risk of a re-occurrence of a new wave of infections is very high when the movement control order (MCO) is lifted. Economic activities have to resume, so we will have to practise some form of restricted MCO for the next six months.

And this affects business.

Sales will continue to be very soft as consumption drops due to lower consumer confidence, higher unemployment and reduced personal income, as widespread paycuts are implemented. As in most recessions, not all businesses will do badly. From experience, consumers tend to trade down, ie, purchase lower-priced alternatives to sustain their lifestyle. Hawker stalls will continue to do well, while higher-priced restaurants will suffer.

The logical conclusion for SME owners is to focus on surviving the next six months. Once the moratorium on your loans ends in October, will you still be standing with the ability to start repaying them? Will you have sufficient cash flow to participate in the economic recovery which will probably start in 2021?

Your survival strategy till October will have to focus on two key issues - 

• cash flow and 
• monthly operating costs.

Managing cash flow 

> Sufficient banking facilities - Since all your loans have been placed under a moratorium (meaning that you won’t need to repay them for the next six months) by your bank, you will need to check if the balance amount of banking facilities will allow you to trade normally.

If not, quickly apply to your bank for additional trading facilities. If you have spare cash, it might be wise to start paying down your loan when you can and not wait till the end of October.

> Cash reserves - You will need to cover March and April losses from your cash reserves. Reduce your losses for the next five months through aggressive cost-cutting. Most businesses will face delayed collections so cash reserves, if available, will be most useful to cover cash-flow deficits.

> Wage subsidy - Expect delays in your claims as the government will not be able to cope with the massive influx of applications. If approved, expect delayed payments of at least a month in your cash-flow planning. The wage subsidy is only for three months but you need to survive the next six months. So, plan accordingly.

> Corporate tax - For companies that will definitely declare a loss in 2020, my advice is to write in to the Inland Revenue Board informing them that you will declare zero profits for the financial year-end 2020, and suspend all tax payments for future projected profits. There is no point loaning the money back to the government when you need it more to survive.

> Deferred EPF payments - Just like bank loans, EPF payments have been deferred for six months when you will have to restructure your payments with the agreement of the EPF. Do not consider this as savings. It goes into accounts payable, interest-free of course.

> Rental subsidy - The announced tax deduction for rental rebates of 30% for three months from April to June will be effective in encouraging private-sector landlords to implement only if double deduction is allowed. In times of need, business partners should help one another. This is how the Chinese business community has been built over the last 100 years in Malaysia.

This is probably the best Bank Negara strategy to help preserve cash-flow liquidity for businesses to continue trading. By allowing the banking system to prevent classifying non-payments after three months as non-performing loans (NPLs), businesses can breathe and continue trading for another six months. Individuals too have more cash in hand to offset the paycuts that will definitely happen. By end-October, Bank Negara must allow another restructuring of existing loans by another six months to businesses who will benefit from the economic recovery.



Reduce monthly operating expenses.

The survival of your company depends on the amount of cash reserves you have to fund losses in March and April and also losses to be incurred from May to October. So, it is imperative that losses are kept to a minimum in the next five months.

Losses are calculated after deducting expenses from net sales. Net sales is gross sales less cost of sales. So, if net sales are down, expenses must come down proportionately, which in this case might not be possible for companies which suffer a big drop in sales.

While your sales revenue is dependent on external factors which are beyond your control, to a major extent, you are in control of your own expenses. For most service companies, payroll forms the biggest portion of the monthly expense. This is normally followed by rental or in some companies, advertising and promotion.

> Rental - At the maximum, expect your landlord to give you a rebate of 30% from April to June. This means that you can factor into your expenses a reduction of 15% in rental payments for the next six months.

> Advertising and promotion - It has been proven in the last recession that companies that continue advertising and conducting promotional activities will sell more than their competitors who stop completely. You are advised to work with your media suppliers to get more bang for the same budget. I am sure the media companies will support you, as they too need sales and have excess inventory to give away.

> Office expenses, allowances and claims - Cut all the unnecessary frills that you can ill-afford. Not much but every penny counts. Spend some on healthcare, though, to look after the team.

> Wages - I have stopped comparing with the Singapore government’s wage subsidy plan because our government does not have sufficient reserves.

With the latest proposed enhanced wage subsidy, it looks like SME owners must take matters into their own hands. Some companies will enjoy reasonable support of up to 30% subsidy on the wage expense, while some will only enjoy 5% to 10%.

Do remember that this is only for three months. Why the government is not exempting EPF payments for six months is beyond my understanding. This will only translate to a higher paycut across the board.

I have an investee company where the senior management has given the board of directors a revised sales forecast, with sales revenue dropping by 20% against the 2020 budget. But no corresponding reduction in expenses was given.

I have replied that this sales forecast might not be achievable and that we should start looking at reducing our expenses, mainly the payroll, which is a massive portion of it.

I would recommend a minimum 20% paycut across the board, freezing all intakes, probably retrenching a few positions deemed not necessary and linking the paycut to sales. If the sales for May to October drop by more than 50%, then the paycut will be more severe like 30%-40% for those who earn above RM4,000. However, if sales recover to its original budget then the salary will revert to its original amount.

Different companies will have to tailor different strategies, depending on the sales performance of the company up to October. For companies where payroll forms the bulk of expenses, detailed human resource requirements must be considered.

Where possible, the fixed salary cost should be changed to a variable cost, as a percentage of sales. This will help minimise losses to a great degree and at the same time save jobs and keep your key employees employed.

Some form of right-sizing is required now. Where possible, eliminate jobs to reduce 10% of your current payroll. Then undertake a paycut of 20% to make total savings of 30%. Then, submit for wage subsidies to the government if your company qualifies, which will probably save you another 5% to 10% of your existing payroll. With immediate savings of 35% to 40% from payroll deduction, you can take your chances with the remaining five months, of which April is already a complete loss for you.

Then my entrepreneur friend asked, “What if the employee does not accept a paycut?”. My answer: “Nobody can stop this employee from leaving the company on his own free will.”

At this moment of truth, SME owners’ only objective is to save the company from going bust. Minimise the losses so that you can stretch your reserves till October.

At the next moment of truth in October, SME owners will have to decide whether to continue or close their business. Don’t forget that you still have deferred EPF payments and the loans with interest to pay off. You can avoid bankruptcy if your business is still alive in October 2020.

From one battle-scarred entrepreneur to all the young entrepreneurs and SME owners out there: “Stay alive today to fight the next battle tomorrow. And you will win again.”

Views expressed here are the writer’s own.



https://www.thestar.com.my/business/business-news/2020/04/08/cash-flow-and-monthly-operating-costs-are-key