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Even profitable companies go bankrupt

Bridget Holmstrom - Sunday, April 12, 2015

Why do profitable companies go bankrupt

Although it seems counter-intuitive profitable companies can certainly go bankrupt.  This is well supported by news reports and research.  So why does this happen well again perhaps counter-intuitively this occurs when the company is going through a period of significant growth perhaps when coming out of a recession or as a new business start-up in a rapid start up stage.

So what happens?  Firstly the business takes on a customer or group of customers that are significantly bigger than any contract they have taken on before.  This means that they have to employ new staff and/(or) buy raw materials in order to fulfil this contract.  It is likely that these suppliers and most definitely the staff will expect to paid before the customer has received delivery of the product or service.  In some manufacturing companies this might be for several months.  If these outgoings are greater than the cash resources available to the company then the company will run out of cash before the customer pays the invoice.  

Bankruptcy is even more likely if the bank is not prepared to extend the overdraft something which they are not obliged to do.  

If the company does not carefully forecast the cash requirements arising from the new contract then it is more likely that the company will go bankrupt.  It could be argued that preparing the cash flow forecast will discourage the business from taking on the new contract because the managers can see that they will run out of money.  But surely it is better to forego the contract and remain in business than take ill-considered risks and fail.

This is another article that you may like to read.