What is more important -- solvency or profitability?

BY: CARIBBEAN CORPORATE GOVERNANCE INSTITUTE

Tuesday, October 06, 2015

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It is obvious to business people that companies should make a profit in the long run as otherwise they will go out of business. However, it is much less well known that most organisations fail because they have not been managing their cash flow and have become insolvent.


In the short run, survival of the company depends mainly on ensuring that bills from creditors can be paid; it is not about making insufficient profit. This article explains what every director needs to understand about their company making a profit and being able to meet its financial obligations.


Profitability


You can easily determine if your company is profitable by analysing its income statement or profit and loss account. However, there are many different profits identified and for some people it is not clear which profit figure to use.


Whichever profit figure is used, directors and managers need to consider whether the profit is growing in proportion to the size of the business (the larger the business, the higher the absolute amount of dollars that the organisation should be generating). In addition, the senior management team should consider whether the company is making at least as much profit on new/extra sales as it is on existing sales. In particular, the profit figure should always be in excess of the cost of capital and should at least be broadly similar to other companies in the same sector.


Many of the current debates concerning the economic sustainability of a company's operations use the economic profit figure. Peter Drucker, the management guru, once said that accounting profit is never enough and that: "A business that does not show a profit at least equal to its cost of capital is irresponsible: it wastes society's resources. Economic profit performance is the base without which business cannot discharge any other responsibilities, cannot be a good employer, a good citizen, a good neighbour."


However, the economic profit is technically very difficult to calculate and therefore few organisations are using it in practice.


But making money is not enough!


So being profitable and making money is not enough! Every director needs to understand the nature of financial risks for the company. No exceptions. 'Making money' now and showing calculated profits for years to come does not mean that all is well. Important risks exist, and insolvency is one such risk. It is no longer sufficient for a director to simply ask, "What's the bottom line - are we making a profit or not?"


The board of directors must examine the level of solvency within the company. If a company is insolvent it means that an organisation is either unable to pay its debts, or its liabilities and debts listed in the balance sheet exceed its assets. If the debts don't get paid, then the insolvency will lead either to bankruptcy for individuals and sole traders, or the company will be wound up or liquidated. In addition, the directors' control over the company will cease and the company will cease to trade, its assets will be sold and the proceeds will be distributed among its creditors.


The solvency ratio (total liabilities / total assets) and the leverage ratio (total liabilities (debt) / total equity) are the most common methods for evaluating insolvency. For many companies an increased insolvency risk is likely to be very troubling because it becomes more difficult and expensive to obtain credit or for the refinancing of debt.


The insolvency definitions used in the Caribbean are essentially identical. In Jamaica, according to the Companies Act, Section 221-- "A company shall be deemed to be unable to pay its debts-


(a) a creditor, by assignment or otherwise, to whom the company is indebted in a sum exceeding five hundred thousand dollars then due, has served on the company, by leaving it at the registered office of the company, a demand under his hand requiring the company to pay the sum so due, and the company has for three weeks thereafter neglected to pay the sum, or to secure or compound for it to the reasonable satisfaction of the creditor; or


(b) if execution or other process issued on a judgment, decree or order of any Court in favour of a creditor of the company is returned unsatisfied in whole or in part; or


(c) if it is proved to the satisfaction of the Court that the company is unable to pay its debts, and, in determining whether a company is unable to pay its debts, the Court shall take into account the contingent and prospective liabilities of the company."


Many companies in Trinidad and Tobago have experienced profitability and solvency issues. Perhaps one of the most well known cases is Trinidad Cement Limited (TCL). Significant capital restructuring has been agreed by the board of directors to deal with the losses and lack of solvency in 2014.


Some business commentators regard solvency versus profitability as a false dilemma. They argue that both are important and that companies need to monitor both closely. On the other hand, other experts argue that a company cannot realise its potential profit if it can't remain solvent along the way. They argue that the relative importance of solvency versus profitability depends on the time horizon that is being used.


If you are focusing upon a short-term time horizon, then solvency is more important than profitability. If however, you are focusing upon a medium and longer-term time horizon then profitability will become relatively more important.


In a future article we will discuss the solvency regime in the Caribbean.


This column does not constitute legal advice. Readers are advised to seek professional advice for their specific situations. The CCGI is an independent, non-profit, professional membership organisation registered with the Accreditation Council of T&T. CCGI is the award body that provides the Certificate and Diploma in Corporate Governance and the Chartered Director qualification throughout the Caribbean. CCGI welcomes membership applications and participation in its courses and events throughout the region. Visit our website for more information and to leave comments on our blog: www.caribbeangovernance.org Non-members can email comments and suggestions at info@caribbeangovernance.org


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