It sounds counter-intuitive that a profitable company can become insolvent but it happens. How? It’s all to do with cash.
Some ways of being profitable and going broke:
- Grow too quickly. A WA winery sold wine profitably that it had made two years previously. The cash collected from customers (at the level of production two years ago) was less than the cash paid to suppliers and employees at today’s much higher level of production. Result: insolvency
- Too much inventory. A just-profitable electronics retailer was buying too much inventory to ‘stock up’ so the cash it collected from sales barely covered cash paid to suppliers and employees. Result: insolvency
- Don’t collect receivables fast enough. A telecoms company operated profitably but its Finance systems were a mess and it couldn’t send invoices to customers so no cash came in. Result: insolvency
- Pay too much dividend. Dividends aren’t costs (they’re a distribution of profit) so if a profitable company pays too much dividend it can easily go broke. It happens.
Profitability is important but so is cash management. The Financial Statements tell you all you need to know. It’s imperative that you know how to read them.