Just think: If more people were financially literate, there might never have been a mortgage crisis in the US, or a Swiss franc lending crisis in Hungary and other CEE countries. While everyone certainly has their fair share of blame with respect to the recent crisis – Governments could have regulated better and financial institutions may have done better risk management – ultimate responsibility for financial decisions still rests with the individuals that make financial decisions at the micro level. Hence the theme of this article is that financial literacy, and therefore financial education, must be at the root of averting future financial crises.

Financial literacy is not just required for entering into loans, mortgages, but for other basic life decisions such as how much to save for retirement, buy appropriate types and levels of insurance, making appropriate investments, etc.

The US Financial Literacy and Education Commission defines financial literacy as “the ability to make informed judgments and to take effective actions regarding the current and future use and management of money.” It is of importance to virtually all parts of the economy – households, businesses, farmers, and so on.

Lets look at some of the symptoms of financial illiteracy in Central Europe today:

• The vast number of households who have taken Swiss franc loans in various Central Europe betrays a lack of awareness of financial risks.

• Huge segments of the population are underinsured.

• Huge segments of the population do not save for retirement, lacking an understanding of the power of compound interest.

• People, like lemmings, tend to buy stocks when markets are rising, and sell into down markets.

• May households in Central Europe invested the vast majority of savings into housing, often believing that housing could not go down. Diversification of portfolio, and of asset classes, is vital.

• The lack of financial literacy, sometimes even among owners of companies, surprises me. I have had long discussions, for example, with a number of CEOs of major companies who look at equity as free money, cheaper than debt.

Financial literacy may be likened to a vaccination. If a certain percentage of the population is vaccinated, a disease like polio cannot spread, and may therefore be eradicated. Might financial education help achieve a similar result, eradicating, or at least diminishing, the down cycle in recessions?

Do we have the level of confidence in financial regulators that they will get the regulations right? And do we have confidence in financial institutions to get their risk management right? Without wishing to take anything away from such efforts, are we not missing part of the equation, namely getting people to make their own financial decisions in an informed and professional manner? I would argue that financial literacy needs to be part of the answer. The best protection is an informed consumer.

So how might we promote financial literacy? While I encourage individuals to research on the web and read extensively, there are also a number of government-sponsored programs:

• Many governments, such as in the US, UK and Australia, have programs in place to promote financial literacy (although I am not aware of any such programs in Central Europe).

• The Organization for Economic Co-Operation and Development has extensively researched best practices with respect to financial literacy in its member countries.

• A number of US states have made courses covering financial literacy available in schools.

• Australia mandated that its schools must provide a curriculum of financial education, and established a Financial Literacy foundation, and financed the training of 2,000 teachers to teach financial literacy.

In short, at the micro level, financial literacy can make the difference between a family prospering, versus being financially wiped out. At the macro level, it can make the difference between the growth or diminution of the middle class. Possibly the rich get richer and the poor get poorer, as the saying goes, because of financial literacy, or lack thereof.

As the author of this column, which appears every two weeks, one of my missions is to help promote financial literacy.

(a) Governments hold debt under control (e.g. the red line might see dramatically reduced growth, level off, or decline). In this case, due to the cessation of credit growth, our economic growth (and hence consumption and standards of living) will stagnate or deteriorate. 

(b) Debt returns to its old exponential growth pattern. This might happen if there is too much social resistance to deficit cutting, in which case governments may choose the less visible route of printing money and piling up debt through deficit spending. Steroids might make us temporarily feel better, but then we could be setting ourselves up for hyperinflation, possibly an eventual even bigger crash, as debt levels become even more unsustainable.

Running a small or medium-sized enterprise (SME) can be compared to piloting an aircraft. In the achievement of your objectives, you keep your eye on certain controls. As velocity and altitude are typically the two most important gauges for a pilot, for the owner of an SME, it is usually profitability and cash flow. Too often, SME owners will neglect cash flow. This may result in the business equivalent of crashing an aircraft into a mountainside.

So why is cash flow so important?

First, cash is like the gasoline in an aircraft or automobile. You run out, you crash. New companies, particularly in the hi-tech business, talk of a “burn rate”: the higher your overheads, the faster your gasoline is being depleted, the faster you must either reach cash break-even or get a cash infusion, failing which, you crash.

Second, many businesses are seasonal. Even though they may be highly profitable, they may require huge amounts of cash at certain times of year (like when inventories and receivables are building up), and throw off huge amounts of cash at other times of the year, (like when inventory and receivables might be declining). The cash flow in seasonally positive months may easily give a false sense of security. Like a predator in the jungle that must ensure it has enough energy to make it to the next “kill,” the SME owner must ensure that there is enough cash even in the good months to make it through the entire cycle.

Third, cash is also a buffer that protects a business in any down cycle. If the bottom falls out of the economy – and your company’s sales – your cash buffer will determine how long you can survive and whether you will survive until your sales pick up again. Deceptively, many businesses with cyclically declining sales are cash-flow positive; as receivables diminish, they are turned into cash. Such businesses survive downturns very well, only to hit a wall when they are recovering, where receivables once again begin to accumulate.

Fourth, cash flow may be strained whenever there is a capital investment program. Will your business have enough gasoline to take it not only through the capital investment program, but also the increase in sales required to pay off any bank loans, etc., associated with the investment? One of my clients entered into a €10 million investment and expansion program, only to find out that the expected revenues from the expansion did not materialize due to the recent recession. It helps to do the analysis beforehand.

Finally, banks usually monitor cash flow, and will often prescribe cash flow coverage ratios (such as cash flow during any given period must be a minimum of X times interest, or Y times principal and interest).

One of the most important exercises that the CFO or financial manager should do is a Profit & Loss / Cash Flow Statement. This is vastly superior to the “back of the envelope” liquidity calculations that most SME’s employ. Generally, an excel spreadsheet will suffice, and it is generally not difficult to create a spreadsheet that will give you both P&L and cash flow statements. Make the statement as “granular” as you require the information—weekly, monthly, or quarterly, and for as far out as you need it: a minimum of one year, but could be for multiple years.

This type of forecast should not be performed annually and then forgotten until the following year. Rather, it should be a “living” document, updated periodically to reflect up-to-date information. It may also be used for sensitivity analysis: “what if” decisions. What if the company were to engage in a new investment? What if the company were to open a new office? What if the company were to take on a new product line? Or open a new warehouse? All of these “what if” decisions may be quantified. And not only will the owners and management of the business be able to ascertain whether or not such decisions will crash the business from a cash flow perspective, if one uses the cash flow forecast to calculate Net Present Value, one may also ascertain whether the decision is accretive to the value of the business, or diminishes its value.

Performing this type of analysis regularly is an important step forward in the corporate governance of a company. The vast majority of investors will require this type of information. You might say that it is the business equivalent of moving from Visual Flight Rules to Instrument Flight Rules, which allows pilots to fly also through fog or through the night. It may be an important step in leaving behind “crisis management,” to building a real company.

Bond auctions across Europe indicate that interest rates on Italian and Spanish bonds are rising to unsustainable levels, and even German bonds (Bunds) are experiencing hiccups … (This is no longer just about Greece). A month ago, the demise of the euro was considered a long shot. Now it’s more a question of what can be done to save it.

Where is decisive leadership in Europe?

So far, the silence is deafening.

Much of the action taken by European authorities has been counter-productive. By making the Greek haircut to banks consensual (e.g. so that the haircut would not technically qualify as a “default”), so that owners of Greek Credit Default Swaps could not collect any insurance with respect to the Greek default, future investors in euro-denominated bonds (e.g. Spanish or Italian debt) would rather not take their chances (with or without CDS’s). If a 50 percent haircut is not a default, then what is?

This fiddling with rules has only served to increase the reluctance of investors or banks to lend to any European government, helping to increase borrowing costs across the European Union, at the worst possible time. A perfect example of how fiddling with the rules for self-serving advantage only serves to dig a deeper hole.

Now to translate the uncertainty surrounding the euro to the level of the man-in-the-street.

• Will the euro cease to exist as a currency? If so, what will happen to contracts denominated in euro?

• Will one or more economically weaker countries resign or be dropped from the euro zone, in which case there might be an even stronger “core” of euro zone countries? in such a scenario the Euro might even emerge as a stronger currency than today.

• Unless dramatic action is taken to rescue the euro, if it does not cease to exist as a currency, it may become substantially weaker. This may create windfall profits and losses among parties to euro-denominated contracts. I, for example, have entered into a lease agreement with option to sell a house in euros. If the euro collapses, my lessee will only be too delighted to purchase the house in vastly depreciated euros. There are most likely millions of such contracts, both inside and outside the euro zone, which would create grief for the contracting party suffering from devaluation.

Bottom line: if the euro were to collapse in value, this is likely to create massive and unintended wealth transfers, creating windfall profits for some, and great difficulties for others.

In Central Europe, Slovenia and Slovakia were very fast to join the euro zone. Poland, Hungary and other Central European countries may be thankful that they did not immediately rush into the Euro. Under the above scenarios, having a local currency may provide degree of insulation from the Eurozone difficulties. Wouldn’t it be ironic if the zloty and the forint would become safe havens from euro-zone fallout?

The world waits with baited breath to see whether Germany and the wealthy members of the euro zone have enough at stake to depart from their strategy over the past few years of providing “too little, too late” in defence of the euro, and carry out a definitive last minute rescue of the euro, and to see what form such a rescue might take.