“If I’m Making All This Money… How Come I’m Broke?!”

PPresentation byresentation by

RRalph Dazet, CPAalph Dazet, CPA

1

“If I’m Making all this Money …

How Come I’m Broke?”Introduction

► Informal

► Ask questions

2

In the 50 years I have been practicing

accounting, this question has frequently been asked

by my clients…

This session is designed to help answer that question!

3

What Will our Methodology Be?

► As usual, we will use a case study – the good ole – “Tie ‘Em Down Good Company”!

(A metals distribution company servicing the

marine and aerospace industries.)

4

Tie ‘Em Down Good, Inc.Financial Highlights

Three Years Ended December 31, 2011

Revenue

Gross Profit% of Revenue

13,636,000 10,140,00011,458,000

12/31/11 12/31/10 12/31/09Year Ended

Pre-Tax Income

Income Tax

% of Revenue

Net Income % of Revenue

Operating Expenses% of Revenue

3,136,00023%

682,000

267,000

2,454,000

415,000

18%

5%

3%

2,750,00024%

573,000

223,000

2,177,000

350,000

19%

5%

3%

2,636,00026%

608,000

237,000

2,028,000

371,000

20%

6%

4%

OPERATIONS

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Days of Purchases

Working CapitalRatio

Accounts Receivable

1,041,000

12/31/11 12/31/10 12/31/09Year Ended

Inventory

Fixed Assets, Net

Inventory Turns

Accounts Payable

Days of Sales

FINANCIAL CONDITION

Line of Credit Collateral Coverage

Shareholders’ Equity

1.3 to 1

1,857,000

3,000,000

810,000

1,402,000

2,270,000

1,480,000

49 days

3.5 turns

48 days

1.25

1.3 to 1

1,432,000

2,124,000

704,000

1,064,000

1,619,000

1,065,000

45 days

4.1 turns

44 days

1.30

1.2 to 1

1,155,000

1,745,000

600,000

917,000

1,220,000

715,000

41 days

4.3 turns

44 days

1.40

751,000 575,000

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► The financial statements we last examined – 12/31/11 disclosed:

Strong sales growth;

Strong profits; and

Tight cash flow and a slightly nervous bank

7

What Happens in 2012?

► Part of the dream comes through:

Sales shoot up by 20%.

Gross profit margin holds at 2011 margin!

Variable operating expenses are in line with sales growth!

Receivables, inventory and payables are in line with sales growth!

The company feels they have really managed the growth!

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► The Stage!

The company, in an informal discussion with the banker, assures the banker that things are really looking good in 2012.

Sales are outstanding!

Profits are looking great!

I’m sure we can knock the debt down by the end of 2012!

9

► What will the 2012 financials look like?

The Income Statement

Let’s examine theSummary of Assumptions

used10

Tie ‘Em Down Good, Inc.Summary Assumptions

Year ending December 31, 2012

OPERATIONS

I. SALES 20% growth from 2011

II. GROSS PROFITMaintain 23% gross

margin

III. DEPRECIATION EXPENSEBeginning of year – fixed assets - gross

Expense

$ 910,000Method & life – S.L 10 yrs. $ 91,000

Method & life – S.L 10 yr, mid yr conventionCURRENT YEAR ADDITIONS $ 100,000

$ 5,000

TOTAL $ 96,000

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IV. LEGAL EXPENSE Same retainer as 2011

V. RENT EXPENSESame operating leases and rate as

2011VI. TELEPHONE & UTILITIES5% increase over 2011

EXPENSE

$ 12,000

Telephone $ 35,000Utilities $ 38,000

$ 120,000

VII. INTERESTWorking capital

loan Beginning of year$ 182,000$2,270,000

Rate 8%

Beginning of yearLONG TERM DEBT

Less ½ payments $ 445,000Average balance (37,000)

Rate 9% 36,000$ 218,000VIII. OTHER EXPENSE

All other variable expenses increase at same rate as sales – 20%IX. INCOME TAX

Calculated at historical effective rate of 39.15%$ 343,000

$ 408,000

12

Based on those Assumptions, let’s examine the Income

Statement!

13

Tie ‘Em Down Good, Inc.Statement of Income


Sales $16,363,000

Cost of goods sold 12,600,000

Gross profit 3,763,000 % of sales 23%

Operating Expenses Accounting 35,000 Advertising 16,000 Bad debts 66,000 Delivery expense 32,000 Depreciation 96,000 Insurance – Group 101,000 Insurance – Casualty 144,000 Legal 12,000 Maintenance 40,000 Meals & entertainment 56,000 Miscellaneous 44,000 Office expense 30,000 Payroll tax 133,000 Rent 120,000 Telephone 35,000 Utilities 38,000 Wages – officers 492,000 Wages – office 274,000 Wages – sales 491,000 Wages – warehouse & delivery 414,000 Total 2,699,000

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Operating income $1,094,000

Interest expense 218,000

Pre-tax income 876,000

Income tax 343,000

Net income $ 533,000

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Wow! The sales growth and the

Company’s management of gross profit

margin and operating expenses has

produced a bottom line growth from

$415,000 in 2011 to $533,000 in 2012.

A growth rate of 28%!16

The Balance Sheet

Let’s examine the Summary of

Assumptions used.17



FINANCIAL CONDITION

I.Cash Hold balance @ $

50,000

II.Accounts Receivable Hold @ 49 days Sales per day

Sales $16,363,000 ÷ 360 days = $45,450

x 49 days $ 45,450$2,227,000

III.Inventory Hold @ 3.5 turns

Cost of goods sold $12,600,000 ÷ 3.5 turns

$3,600,000

IV.Prepaids Hold @ $

50,000

V.Fixed Assets Beginning balance, net @ 12/31/11 $ 810,000

Plus current year additions 100,000 Less current year depreciation (96,000)

Net balance @ 12/31/12 $ 814,000

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VI. Working Capital Loan Hold @ $2,270,000

VII. Accounts Payable Hold @ 48 days Payables per day Cost of goods sold $12,600,000 ÷ 360 days 35,000 x 48 days $1,680,000

VIII. Accrued Expenses Hold @ $ 170,000

IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) Balance @ end of year $ 371,000

Current$ 74,000 Long-Term$ 297,000

X. Shareholders’ Equity Balance – Start of year $1,480,000 Current year profit 533,000 Balance @ at end of year $2,013,000 19

► Based on those Assumptions, let’s examine

the Balance Sheet (has the $533,000

bottom line profit earned, enabled the Company to

reduce debt as promised?)

► If all of the Balance Sheet

Assumptions come to pass and the

Company generates a $533,000 bottom line, what

will the resultant net increase or decrease in cash be?20

Tie ‘Em Down Good, Inc.Balance Sheet

Year Ended December 31, 2012

Current Assets

Cash

Accounts receivable

Total current assets

Total Assets

Fixed assets, net

InventoryPrepaid expenses

ASSETS

$ 50,000

5,690,000

3,600,000 50,000

814,000

$6,504,000

2,227,000Cash, increase (decrease)

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Current Liabilities

Working capital loanAccounts payable

Total current liabilities

Shareholders’ equity

Long term debt

Accrued expensesCurrent portion long-term debt

LIABILITIES AND EQUITY

Common stockRetained earnings

Total shareholders’ equity

Total Liabilities & Equity

$2,270,000

4,194,000

100,000

170,000 74,000

297,000

1,680,000

1,913,000 2,013,000

$6,504,00022

-Answer-Cash goes down by ($237,000)

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Why?With a substantial growth in sales

(example 20%), the profits generated will not be able to self-finance the

resultant growth in Receivables and Inventory – even if management is able to hold this Inventory and

Receivable growth in line with sales!

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What happens if management, in its great rush to grow the business,

allows gross profit margins to slip a little and receivable and inventory management to slip a little (look at

history)► We call this “the Norm”!

► Looking back over the Company’s recent history, suppose the rapid sales growth produces the following effect on operations and financial conditions.

Operating Assumptions25



OPERATIONS

All Assumptions are the same as in the first illustration, except for projected gross profit %.

This illustration assumes that the rapid growth in sales (20%) will result in a 1% slippage in gross profit from 23% to 22%.

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Balance Sheet Assumptions

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FINANCIAL CONDITION


50,000

II.Accounts Receivable Slip from 49 days to 52 days

Sales per day Sales $16,363,000

÷ 360 days = $45,450 $ 45,450 x 52 days

$2,363,400

III.Inventory Slip from 3.5 turns to 3.2 turns

Cost of goods sold $12,763,100 ÷ 3.2 turns

$3,989,000


50,000



Net balance @ 12/31/12 $ 814,000

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VIII.Accrued Expenses Hold @ $ 170,000

IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) New balance @ end of year $ 371,000


X. Shareholders’ Equity Balance – Start of year $1,480,000 Current year profit 434,000 Balance @ at end of year $1,914,000

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► If the Assumptions all come to pass, what will the financial statements look like?

The Income Statement

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Tie ‘Em Down Good, Inc.Statement of Income


Sales $16,363,000

Cost of goods sold 12,763,000

Gross profit 3,600,000 % of sales 22%

Operating Expenses Accounting 35,000 Advertising 16,000 Bad debts 66,000 Delivery expense 32,000 Depreciation 96,000 Insurance – Group 101,000 Insurance – Casualty 144,000 Legal 12,000 Maintenance 40,000 Meals & entertainment 56,000 Miscellaneous 44,000 Office expense 30,000 Payroll tax 133,000 Rent 120,000 Telephone 35,000 Utilities 38,000 Wages – officers 492,000 Wages – office 274,000 Wages – sales 491,000 Wages – warehouse & delivery 414,000 Total 2,699,000

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Operating income $ 931,000

Interest expense 218,000

Pre-tax income 713,000

Income tax 279,000

Net income $ 434,000

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The (1%) drop in gross profit margin reduced net income from

$533,000 to $434,000 (which is still ahead of prior

year results of $415,000)!

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Balance Sheet

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Current Assets

Cash

Accounts receivable


Total Assets

Fixed assets, net


ASSETS

$ 50,000

5,615,000

3,989,000 50,000

814,000

$6,429,000

2,363,000Cash, increase (decrease)

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Current Liabilities




Long term debt






$2,270,000

4,218,000

100,000

170,000 74,000

297,000

1,704,000

1,814,000 1,914,000

$6,429,00036

Based on those Assumptions, let’s examine the Balance Sheet.

What has this $434,000 bottom line from operations produced?

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-Answer-Cash goes down by $837,000 …

OUCH!!!

If our historical trends continue, the Company may NOT be able to finance this growth.

Yes, Virginia…

"You can sell yourself out of business!"

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How do we solve this problem?► Slow down sales?

Is this an acceptable answer for almost all companies?

► Monitor and target acceptable levels of “Days of Sales” and “Inventory Turns” Assign responsible people to monitor and have

definite reporting schedules with a set meeting schedule (no less than once a month).

Further slippage is NOT acceptable – the Company cannot reasonably expect to finance a $837,000 negative cash flow!

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► At the start of the year, the Company must prepare,

very carefully, a realistic Operating and

Cash Flow Budget.

All effected parties:

a. Ownership;

b. Sales department;

c. Inventory department; and

d. Accounting department

must provide input and acceptance!

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► After this operating and cash flow budget is prepared, management must meet with its commercial lender and determine the lender’s approval of the Company’s plan and obtain from the lender a commitment of their participation.

► If management anticipates continued future growth of this magnitude, the Company should begin to explore additional sources of capital.

Expanded investment from existing stockholders.

Possibility of investment by individuals who are willing to be minority shareholders.

Venture capital groups.

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Let’s not lose sight of the best solution!

► Management learns to manage the Balance Sheet as well as it manages the Income Statement!

► What would happen if instead of “holding our own”, the Company actually improved its management of:

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FINANCIAL CONDITION


50,000

II.Accounts Receivable Improve to 45 days

Sales per day Sales $16,363,000

÷ 360 days = $45,450 $ 45,450 x 45 days

$2,045,400

III.Inventory Improve to 4.1 turns Cost of goods sold $12,600,000

÷ 4.1 turns$3,073,000


50,000



Net balance @ 12/31/12 $ 814,000

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VIII. Accrued Expenses Hold @ $ 170,000

IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) Balance @ end of year $ 371,000


X. Shareholders’ Equity Balance – Start of year $1,380,000 Current year profit 533,000 Balance @ at end of year $1,913,000

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“Days of Sales” from 49 days to 45 days

“Inventory turns” from 3.5 turns to 4.1 turns

What would the Balance Sheet look like then? (Remember when the Company

“held its own”, with a 20% growth, the $533,000 net income turns into a

$(237,000) negative cash flow.

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Current Assets

Cash

Accounts receivable


Total Assets

Fixed assets, net


ASSETS

$ 50,000

5,690,000

3,073,000 50,000

814,000

$6,504,000

2,045,000

Cash, increase (decrease) 472,000

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Current Liabilities




Long term debt






$2,270,000

4,194,000

100,000

170,000 74,000

297,000

1,680,000

1,913,000 2,013,000

$6,504,00047

► As disclosed in the following illustration, the net effect of the improvement in receivable “Days of Sales” and “Inventory Turns” would convert to a negative cash flow of $(237,000) to a positive cash flow of $472,000.

► Is this possible?

The 45 Days of Sales in the illustration merely returns to 2010 results.

The 4.1 Inventory Turns in the illustration merely returns to the 2010 results.

It should be noted that these results are in the mid-range of performance for the metals distribution companies in the Robert Morris survey and the Metals Distributors Trade survey published results. 48

How Can We Best Monitor and Improve Performance in this

Cash Flow Area?► Review past history and use this understanding to

predict future results.

► Improve our ability in projecting cash flow.

► Develop acceptable “benchmarks” of performance.

Assign responsible management personnel to monitor and report on these results with a formal meeting schedule.

Develop a reward system for acceptable performance.

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► Develop a program to meet with the Company’s commercial lender in advance, and

Lay out the Company’s expected operating results and projected cash flow results.

Obtain a commitment from the lender that they are willing to meet our commercial lending needs for the following year.

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“If I’m Making All This Money… How Come I’m Broke?!”

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