Bringing a Knife to a Gunfight

Last Friday I was listening to Bloomberg radio as I drove to a meeting.

Mohammed El-Erian, the brilliant CEO of PIMCO, was being interviewed on the question of European sovereign debt. Commenting on the assistance provided the Greek government he said that the program amounted to “applying a liquidity solution to an insolvency problem”. The implication was that, in his opinion, the weapon did not suit the battle.

As others might put it, the Euros were bringing a knife to a gunfight.

El-Erian’s words stuck with me, so I thought I ought to brush up on some definitions.

First, insolvency and bankruptcy are two different things. And Dr. El-Erian would know quite well, given his background at the IMF, that countries cannot technically become bankrupt. Bankruptcy is a legal concept that does not extend to sovereign entities.

Insolvency, on the other hand, is a financial condition. More accurately, there are two financial conditions associated with the term insolvency.

1. “Balance sheet insolvency” is the condition in which liabilities exceed assets, and

2. “Cash flow insolvency”, meaning that a company cannot meet its payment obligations on time.

The cure for balance sheet insolvency is a capital cure; increasing assets, decreasing liabilities, or some combination of the two that results in a positive capital account.

But, what is the cure for cash flow insolvency?

The condition has two elements: a) payment capacity, and b) time.

So the approach to a cure for cash flow insolvency (absent a reduction in the actual amounts due) will have to be a combination of increased payment capacity and extended payment terms. Both of which are liquidity solutions.

In fact, absent the steps noted above with respect to balance sheet insolvency, the only REAL solutions for cash flow insolvency are LIQUIDITY solutions.

Moving from a discussion of the rarified issue of sovereign debt to the arena in which Buyers and Sellers on The Receivables Exchange spend their time, the realities include:

1. A large percentage of private businesses in the small-mid-size space are “balance sheet insolvent”.

The liability protections and the tax treatment of the S-Corp and the LLC, which dominate private business ownership structure, create a bias in favor of minimizing assets left in the business. Especially in companies with high depreciation expenses; these structures tend to generate negative net worth over time.

2. The balance sheets of many businesses in the SMB space tend to reflect the personal finances of the owners as much as they do the financial results of the companies.

For instance; often the liabilities that make the business “balance sheet insolvent” are loans due to the business owners, which would likely be treated as capital contributions in other circumstances. The odds of a business owner forcing a solvency crisis by accelerating a loan due him are (usually) low.

3. Many businesses in the SMB space are not far from the start-up phase and the early-period losses still dominate the balance sheet.

4. It is the income statement, or more-accurately, the BANK statement, that commands the attention of most private business owners. A high percentage will know their cash position every day. A very low percentage will examine their balance sheet in detail even quarterly.

5. Cash flow is the lifeblood of these businesses. If the bills can be paid and the owners can draw enough cash to meet their personal needs, the fact that the balance sheet shows a negative net worth is not likely to affect management’s decision making, at least in the short term.

6. But, as we all know, it is cash flow that has suffered most during the recent financial contraction and de-levering of credit-granting institutions. And the relative complacency of owners whose businesses are balance sheet insolvent does NOT apply equally to the case of cash flow insolvency.

7. Cash flow insolvency threatens the going-concern viability of small businesses to a far greater degree than balance sheet insolvency.

Many recent studies and surveys have documented that access to cash is the number one problem in the SMB market today.

It is precisely a LIQUIDITY solution that is required for a problem of cash flow insolvency. It might not be a permanent one. It might well be that a capital structure solution is required in the longer term.

But in today’s financing environment the acceleration of cash flow via the sale of accounts receivable might provide the BEST solution for many smaller businesses.

In the world of global sovereign debt finance there might be room to question the KIND of solution used for a financing problem. To a small business owner, though, the existence of ANY solution is a big, and a welcome, thing.

Maybe a knife doesn’t win in a fight against a gun. But if I don’t have any bullets for my gun, the knife looks like a pretty good alternative!