Cost-cutting can mask a company’s declining revenues

General Electric’s tumble should remind companies of the importance of cash flow.

James McCusker

James McCusker

Measured in Wall Street terms, General Electric’s meltdown is nearly complete. In 2008 the company had a market value of $840 billion and was the darling of the Dow. By November 2018, the once dominant firm’s valuation had dropped to $175 billion, and it had been jettisoned from the Dow Jones Industrial average.

What happened? Or, as one business magazine headline screamed, “What the H— Happened at GE?”

The recent history of GE reads like something out of Greek mythology where everything it touched, from milk to ambrosia, turned sour. Every investment, every effort to right the GE ship seemed to make things worse. Investors and stockholders lost confidence in GE’s management and even the company’s CEO has said the firm’s parts might now be worth more than the whole.

Clearly there has been a management failure of colossal proportions. What is less clear is whether there is anything useful that we can learn from the GE story. Few of us will ever manage a business of GE’s size and diversity. But one of its problems, cash flow, is replicated quite often in smaller companies.

How did a gigantic, successful business like GE, known worldwide for the quality of its consumer and industrial products and a CEO that was lionized by Wall Street, get itself into cash flow problems?

The simplest answer is that GE management did not realize that it had a cash flow problem until quite late, and by then it had been embedded into its corporate structure.

Problem recognition was delayed in part by the fundamental strategy set by former CEO, Jack Welch. Looking analytically at GE’s operations he realized that the company had expanded and diversified without a plan, and had become difficult, if not impossible, to manage effectively.

He devised a simple, yet powerful, plan for slimming down. Each product and service area within GE would be examined and its fate determined by a simple standard: if GE couldn’t be the No. 1 or No. 2 producer in that market, they would sell off their investment and get out.

The plan worked, and because GE was so large and had diversified into so many areas, it worked for years. As the company shed these marginal operations its profit margins and return on investment improved. Stockholders loved it. Everybody loved it.

The only problem did not seem like a problem at all. The selloff of unpromising subsidiaries, though, creates a positive cash flow that could mask a chronic cash flow problem that was building within GE.

In some of the key earnings areas of the company, the time lapse between production costs and payments by the customers could be months and even years. GE management believed, quite rightly, that the most accurate picture of its financial position would offset the costs embedded in these products by recognizing profit before any payment had been received.

There is nothing wrong with this accounting method and certainly taxing authorities often encourage or even require it. And as a going concern, the financial picture it presents is “truer” than the alternative, which could portray a company whose expenses were out of control. Smaller companies commonly experience similar problems of when to recognize profits. There just aren’t as many zeros after their numbers.

The problem at GE was that recognizing the profits in that manner masked the cash flow issues involved in these long-time-lapse products. And when the sale of less-competitive investments brought in a steady flow of cash, it was easy for management to forget that they had an underlying cash flow problem.

It is possible that these combined effects made it easier for management to start believing their own reviews — that it was the best company that ever was, and they were all superb managers. We cannot know that it happened that way, but surely the temptation was there.

What lessons can those of us in smaller companies take away from GE’s history? The first is that you cannot manage your company from your financial statement. You have to manage your cash flow, too. Also — and this can be important — you have to understand your cash flow process well enough to explain it to your bank, because your cash flow may need occasional or regular financing.

The second lesson is that cost cutting is not a winning strategy; it is a survival strategy. And GE’s selling off its less promising investments was not a winning strategy. It was strictly defense, wearing a winning strategy’s jersey. If your company needs to cut costs, then cut costs. But that, by itself, will not bring in a single new customer or an additional dollar of revenue. That takes a winning strategy.

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