Written by Banudas Athreya on 07 May 2019
We have heard a lot about the Ponzi schemes in the investing world.
A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of the money paid by subsequent investors rather than from profit. This term is largely used in the Investing world but is pervasive in all walks of lives and business.
For example if you repay old personal loans by taking fresh loans and not out of your income it is a ponzi scheme.
We have to examine it in the other businesses as well. The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going. The system is always destined to collapse because the earnings, if any, are less than the payments. Whenever the scheme is unable to entice investors to meet the current obligations, it comes down crashing.
We have to examine this in all the different businesses in different sectors. Ponzi applies to all of them and it is important for the finance executives to pay sufficient attention to the details of the financials to save the Company from entering into this trap. It need not be necessarily fraudulent but would result in a good business going bad very quickly.
Cash flow management is meticulously undertaken by most Companies. There us a tendency to accelerate collections from Customers and collect as much advance as possible. But actual delivery may happen much later. These advances may be used for funding current operations or losses. If this continues for some years you will not have a problem as long as new business keeps growing. Once there is a slowdown in the new business then there would not be enough money to deliver the current projects resulting in Bankruptcy or Bailout. Let us examine some sectors where this is a high possibility
Real Estate : It is very highly possible in real estate sector. There are advances taken from customers. It is important that these advances are used towards the projects they are taken for. . If these funds are used to fund earlier losses in the projects we have a ponzi scheme brewing. . But if there is a slowdown in growth of new Business it will not take long before the business gets to Bankruptcy.
Aviation : Tickets are booked in advance in most cases at deep discounts. The earlier you book the better is the discount. Watch out for using this money in funding current operations. Working at those prices is not a viable option.
Auto & Other manufacturing: Advances are collected for importing components, assembly and manufacture. The likelihood is lesser here but nevertheless possible. If the cycles are short, then the possibility is much lesser.
Here are some suggested tips to avoid falling into the trap
· Analyse profitability and Cashflow through each project.
· Avoid managing BU cash at the Corporates. Take only the profits from BU for treasury
· Review liabilities periodically and ensure adequate current and quick ratio always
· Assess right working capital needs and raise through equity and adequately manage Working Capital
· Never let current liabilities fund anything other than Quick assets
During these recessionary times it is important for corporate to adequately manage profitability and cash. This is also the time when one can fall prey to faulty practices that hide the true picture. Ensure adequate cash management for building a successful corporate.
