About a month ago I read an article about a company that sought protection under Chapter 11 bankruptcy laws for a “clerical error”. As they say: “You just can’t make this stuff up.” The headline actually blamed it on tax bills which arose as a result of the clerical error. To suggest that either tax bills or clerical errors are the root cause of a company failure is foolish. Tax bills (in this case for employment taxes) aren’t a surprise. They are a cost of doing business. I assume this is a case of management and its lawyers trying to put some public spin on the problem. Of course, it could be the case that they actually believe this.
The root cause is some combination of not being able to make the business model work in the current economic environment or management being asleep at the wheel. Given the spurious comments from management and their counsel, I’m betting on the latter.
There is a relationship between net income and cash. The exact relationship depends on many factors For example, growth businesses can be net income positive but need cash to support investments in inventory, capital expenditures and expansion. For a business that is relatively stable with little capital investment requirement, the relationship between net income and the change in cash might be one for one. In other words, depreciation might roughly offset new capital investment. Receivables and payables might vary on a month to month basis, but over the course of several months or a year, don’t change very much. Alternatively, it might be a business where most customers pay by cash or credit card which means the business operates with virtually no accounts receivable. In any event, management should understand the relationship between net income and cash flow. To the extent the business is not behaving accordingly, that is a huge red flag.
Further, management should understand all the costs of running the business and know whether they are being recorded properly each month. Will there be accounting mistakes and clerical errors in a business? Yes. One of my companies records approximately 30,000 transactions every month. At 99.9% accuracy that would be 30 mistakes per month. At 99.99% accuracy, that would be 3 mistakes per month. Truthfully, we’re operating somewhere in the middle of that band and working on automation in order run virtually mistake free. That being said, none of the 10 or so errors among those 30,000 transactions are material. The very fact that we know about them says that we have a process which finds and fixes them (often before we close the books). Even if left unchecked, they wouldn’t have a material effect on the financial statements. If it was material (and something which could put a company into bankruptcy is no doubt material) the error would be found and fixed.
It is the responsibility of management to properly present the financial condition of the company through monthly financial reporting. For management to suggest that they didn’t understand the costs of running the business or the financial condition of the firm is simply an indication that they have abdicated their responsibilities. They should be replaced without hesitation.
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