MANAGING

PROFITS

The most difficult achievement in any business is to earn a profit.

Maintaining a competitive edge with products and services in the marketplace, managing people, resources, professionals and the all important sales effort is not easy. It requires so many skills to be a good manager. Congratulations to those businesses that consistently earn profits.

Unfortunately we know that many businesses (and organizations) fail every year and have done so since the beginning of time all over the world - simply because they failed to take in more money than they spend.

The second most difficult achievement is to manage the profits.

Businesses that earn accrual profits yet fail and go out of business, take shelter in bankruptcy or are forced to sell do so simply because they mismanaged their profits and balance sheet. This includes the full range of businesses from Fortune 500 businesses to the very smallest businesses.

Even if failure to manage the profits is discovered early, it may be painful to extract the business from the problem and return to a healthy position.

Many business owners and staff members do not understand the interrelationship between the accrual earnings statement and the balance sheet of a business. A specific schedule prepared by most accountants is the “cash from operations” or “sources and uses of funds” - these schedules contain important data compiled from financial statements.

This article could have well been titled “Managing Your Balance Sheet.” However, lenders, vendors and providers of capital make it easier to grow and to increase liabilities when a business is making profit. And, business owners are more aggressive when making accrual profits. Profit seems to be the principal prerequisite that provides businesses the opportunity to manage or mismanage their balance sheet, so we will stick with our title.

Cash from Operations (Sources and Uses of Funds)

One does not have to be a “rocket scientist” to understand Cash from Operations. It takes a little study but anyone can understand this schedule. If you are the owner or a key staff member it is beyond my comprehension that one would not understand it considering the potential pitfalls. For those small businesses that never really learned to analyze their cash from operations, let us start now and review a very simple version of a cash from operations schedule.

When preparing accrual financial statements - we utilize the double entry system.

.............................................Debit.........Credit

For instance if we sell a product and bill a customer the entry is as follows:

Accounts Receivable............1,000
Sales........................................................1,000

When the receivable is collected:

Cash......................................1,000
Accounts Receivable...............................1,000

An invoice is received by our company:

Telephone Expense................. 300
Accounts Payable......................................300

When the payable is paid:

Accounts Payable................... 300
Cash...........................................................300

These transactions have created entries to the Balance Sheet and Accrual Earnings Statement creating an interaction between the balance sheet and the earnings statement.

Therefore it is impossible to understand how your current cash position was created by reviewing the accrual earnings statement, as all transactions were not exclusively based on cash and we do not know to which extent income (sales) made it to the bottom line as cash or remained in accounts receivable, nor which expenses were actually paid from cash or remained in accounts payable.

Of course there are many other such transactions that effect the balance sheet and cash from operations (sources and uses of funds). Loans being just one.

Let’s review the above cash from operations (sources and uses of funds) schedule. This review is not intended to be boring or overly basic, but this article is directed at a broad scope of business owners - some who do not even understand the simplest concepts or basics.

Earnings Statement

· Profits of $7,000 directly from the accrual earnings statement.

· Depreciation, an expense, is a bookkeeping item only, not a cash expense.

· Accounts Receivable increased and indicates a minus to cash and the impact on cash from this single transaction was negative by $10,500. ($927,000 last month, plus $700.00 sales less $937,500 month end = $689,500, which was collected in cash for the month, $10,500 less that the $700,000 in sales reported in the accrual earnings statement.

· Inventory increased, thus a minus to cash.

· Facilities increased indicating a minus to cash.

· Accounts Payable increased (borrowing from vendors) is a plus as it increases cash.

· Bank Loan decreases cash as a payment was made.

· Internal Revenue, a plus as it increases cash. Borrowing from the government, is not a good idea if it was non-payment of payroll taxes - legitimate deferments of income tax are fine.

· New Loan, a plus as it increases cash.

Add cash from operations and financing to the prior periods ending cash and it must, equal the current periods ending cash.

How do businesses mismanage their balance sheet?

Growth that is growing faster than a “balanced approach” (assets funded by liabilities that match the cash flow generated by the asset) is one of the most common culprits.

Increasing inventories or facilities are normal and desirable, but if the pressure on cash is too great (to pay increased payables, loans or other increased liabilities) under current conditions, then the pressure on cash will be unbearable if the cash flow decreases, due to reduced sales or the slow turnover of accounts receivable.

All growth must be funded by current cash flow, increased liabilities, loans or capital. When funding growth, the shorter the maturity of the funding the greater the risk for the business to provide increased cash flow to repay the liability. Knowledgeable lenders and others analyzing financial statements (current and proforma) apply the quick ratio and current ratio to ascertain if a business has the ability to service its obligations in a timely manner.

An example of balance sheet mismanagement:

A very large, well-known specialty clothing store based in England financed a “extensive” expansion of facilities and inventory with a bank loan. The maturity of the loan was two years. However, the company experienced a drop in sales coupled with increased expenses - the solid earnings became solid losses. The bank, should have never financed the expansion with short maturities. The bank would not renew the loan due to the losses. The company was forced into a very precarious position. The company is now owned by the Japanese, who increased the capital of the company and the cash from that investment paid the bank loan (lucky bank). The strategic plan on how to finance the growth was extremely poor and it created a “do or die” situation. For the management and owners, the outcome was “die.”

A simple example of how even positive growth affects cash flow:

A landscaping business acquires a new large customer, whose contract calls for monthly payments of $18,000 due 30 days after billing. Pricing indicates the business’s profit margin will be 10%.

From day one labor and material are required to service this new customer. Payment will not be received for 60 days, thus the business will be required to invest $32,400 before any cash is received. How does this business finance the $32,400 (current cash, accounts payable, loans, capital) and how long will it take until the front end funds are repaid? In a perfect. simple world, the net profit from this new business will be approximately $1,200 per month, which will be available to justify the outlay of cash from new capital, increased liabilities, or from current cash.

All growth faces similar scenarios.

Balance

Balance - as in balance sheet - is the key to sound management of the balance sheet. Assets funded by Liabilities and Capital.

Are inventories too large for the “real” sales potential? Does the inventory turnover (specific items or variety) justify funding their existence?

Are facilities too costly as they relate to sales and do they justify funding their existence?

Are receivables too high requiring deferring liquidation of liabilities on a timely basis?

When sales, profits and resulting cash flow is on the upswing, balance sheet mistakes can be easily masked; it is when sales, profits and cash flow decreases that mistakes become disasters.

How to avoid building a balance sheet trap?

Prepare financial statements monthly. Do not be penny wise and pound foolish. With all the computer programs available today there is absolutely no excuse not to have monthly financial statements.

Produce these financial statements as soon as possible after the month end.

Create financial and productivity ratios from your financial statements that will measure the productivity of key assets and liabilities, interacting with the earnings statement. This is a must and cannot be stressed enough. Think long and hard about what makes your business “tick.”

Spread the financial statements and ratios monthly, few of us are able to retain enough data in our heads to be effective.

Compare your business to others similar in size and industry. Libraries have resources such as RMA (Robert Morris Associates) and Dun and Bradstreet, which have common sized comparative financial statements and ratios. A word of caution, these are only guidelines, not all businesses are exactly alike.

Educate yourself on how to read and analyze financial statements if you have the responsibility for the business. Accounting is an art, not a science. Notwithstanding, financial statements are the definitive language of business. You certainly can seek advice from others, but I suggest that you understand the financial statements. There are many books that deal with analyzing financial statements. When all is said and done the financial statements are the ultimate reflection of your business.