There are various challenges in undertaking a financial evaluation of a project. One has to look at various facets of the returns (IRR, RoI, NPV), profitability (margins, PAT), leverage (debt, loan, deposits), taxability, risks etc. In a typical corporate house or a financial institution, the task of actually plotting a financial model is relegated to analysts/associates who submit their work to the top management. The top management usually has the back of envelope calculations already done and they then try to see if their intuitive calculations are in the same lines as those of the models prepared by analysts/associates. If the results match, typically, the job is done.
In all these years of discussing cash flows with investment bankers, fund managers, promoters, CEOs/CFOs, one thing that I feel most people tend to ignore is the timing of cash flows, or, to say it more explicitly, envisaging short term cash flow problems. Most people get happy with the big picture, profitability, return etc (which in fact is true), but to reach that big picture goal, one might have to go through short term funding problems. And if one is not prepared to handle the short term issues, it can lead to disastrous consequences, often impacting the long term goals.
The assets and liabilities of a firm can be divided into short-term and long-term. Short-term assets broadly include cash, cash equivalents and inventories—i.e., any asset that can be converted into cash in a short period of time. Long-term assets include assets such as land and building, plant and equipment, good will etc. Short-term liabilities include short-term debt and vendor liabilities. Long-term liabilities include long-term debt and equity. Ideally, long term funds (equity plus debt) should provide for fixed or long term assets plus a certain amount of working capital. As long as short-term assets exceed short-term liabilities, a project will not have day to day liquidity problems.
A serious problem arises when, say, the timing of revenue gets delayed. The project will still make the same amount of profit (if not more) but it needs more funds/capital to achieve it. Is there sufficient liquidity in the system to ensure that ‘short term shocks’ are absorbed? Was the model stress tested to ensure that short funding issues are addressed? In these situations, if short-term liabilities suddenly exceed short-term assets, it can force the company to liquidate long-term assets, increase long-term liabilities, or face bankruptcy. When these events take place, the project becomes distressed and can find that the market for both its assets and liabilities has significantly diminished.
Companies fail if they do not have access to adequate cash to meet their short-term liabilities. Enron’s demise was started by discovery of an accounting fraud, but caused by inability to manage liquidity risk. Financial institution bankruptcies in 2008 were accelerated by the inability to manage liquidity risk. Northern Rock suffered from funding liquidity risk following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets. What destroyed MF Global, Lehman Brothers , Bear Stearns, AIG, and other financial firms was the refusal of short-term lenders to continue lending money to the firms.
Coming back to the original point, estimating short term funding issues should be given special importance and thoroughly looked into while undertaking the financial evaluation of a project. It would typically involved preparing short term cash flows rather than just relying on the profitability statement or the annual cash flows. This exercise would give important insights into deciding the capital structure and the quantum of long term capital required.
