Trend Analysis – Liquidity

Posted by PITHOCRATES - January 7th, 2013

Economics 101

Liquidity can be More Important than Profitability to a Small Business Owner

Small business owners lose a lot of sleep worrying if they will have enough cash for tomorrow.  For next week.  For next month.  You can increase sales and add new customers but unless this creates cash those new sales and new customers may cause more problems than they help.  For a lot of businesses fail because they run out of cash.  Often times learning they have a cash problem only when they don’t have the cash to pay their bills.  So savvy business owners study their financial statements each quarter.  Even each month.  Looking for signs of trouble BEFORE they don’t have the cash to pay their bills.

Investors poor over corporations’ financial statements to make wise investment decisions.  Crunching a lot of numbers.  Analyzing a myriad of financial ratios.  Gleaning a lot of useful information buried in the raw numbers on the financial statements.  Small business owners analyze their financial statements, too.  But not quite to the extent of these investors.  They may look at some key numbers.  Focusing more on liquidity than profitability.  For profits are nice.  But profits aren’t cash.  As a lot of things have to happen before those profits turn into cash.  If they turn into cash.  The following are some balance sheet and income statement accounts.  Following these accounts are some calculations based on the values of these accounts.  With four quarters of data shown.

So what do these numbers say about this year of business activity?  Well, the business was profitable in all four quarters.  And rather profitable at that.  Which is good.  But what about that all important cash?  With each successive quarter the business had a lower cash balance.  That’s not as good as those profitability numbers.  And what about accounts receivable and inventory?  There seems to be some large changes in these accounts.  Are these changes good or bad?  What about accounts payable?  Accrued expenses?  Current portion of long-term debt?  These all went up.  What does this mean in the grand scheme of things?  Looking at these numbers individually doesn’t provide much information.  But when you do a little math with them you can get a little more information out of them.

In Trend Analysis a Downward sloping Current Ratio indicates a Potential Liquidity Problem

Current assets are cash or things that a business can convert into cash within the next 12 months.  Current liabilities are things a business has to pay within the next 12 months.  Current assets, then, are the resources you have to pay your current liabilities.  The relationship between current assets and current liabilities is a very important one.  Dividing current assets by current liabilities gives you the current ratio.  If it’s greater than one you are solvent.  You can meet your current financial obligations.  If it’s less than one you will simply run out of current resources before you met all of your current liabilities.  In our example this business has been solvent for all 4 quarters of the year.

Days’ sales in receivables is one way to see how your customers are paying their credit purchases.  The smaller this number the faster they are paying their bills.  The larger the number the slower they are paying their bills.  And the slower they pay their bills the longer it takes to convert your sales into cash.  Days’ sales in inventory tells you how many days of inventory you have based on your inventory balance and the cost of that inventory.  The smaller this number the faster things are moving out of inventory in new sales.  The larger this number is the slower things are moving out of inventory to reflect a decline in sales.  These individual numbers by themselves don’t provide a lot of information for the small business owner.  Big corporations can compare these numbers with similar businesses to see how they stack up against the competition.  Something not really available to small businesses.  But they can look at the trend of these numbers in their own business and gain very valuable information.

The above chart shows the 4-quarter trend in three important liquidity numbers.  Days’ sales in receivables increased after the second quarter upward for two consecutive quarters.  Indicating customers have paid their bills slower in each of the last two quarters.  Days’ sales in inventory showed a similar uptick in the last two quarters.  Indicating a slowdown in sales.  Both of these trends are concerning.  For it means accounts receivable are bringing in less cash to the business.  And inventory is consuming more of what cash there is.  Which are both red flags that a business may soon run short of cash.  Something the three quarters of falling current ratio confirm.  This business is in trouble.  Despite the good profitability numbers.  The downward sloping current ratio indicates a potential liquidity problem.  If things continue as they are now in another 2 quarters or so the business will become insolvent.  So a business owner knows to start taking action now to conserve cash before he or she runs out of it in another 2 quarters.

Keynesian Stimulus Spending can give a Business a Current Ratio trending towards Insolvency

In fact, this business was already having cash problems.  The outstanding balance in accounts payable increased over 100% in these four quarters.  Not having the cash to pay the bills the business paid their bills slower and the balance in outstanding accounts payable rose.  Substantially.  As the cash balance fell the business owner began borrowing money.  As indicated by the increasing amounts under current portion of long-term debt and interest expense.  Which would suggest substantial borrowings.  Putting all of these things together and you can get a picture of what happened at this business over the past year.  Which started out well.  Then experienced a burst of growth.  But that growth disappeared by the 3rd quarter.  When sales revenue began a 2-quarter decline.

Something happened to cause a surge in sales in the second quarter.  Something the owner apparently thought would last and made investments to increase production to meet that increased demand.  Perhaps hiring new people.  And/or buying new production equipment.  Explaining all of that borrowing.  And that inventory buildup.  But whatever caused that surge in sales did not last.  Leaving this business owner with excess production filling his or her inventory with unsold goods.  And the rise in days’ sales in receivables indicates that this business is not the only business dealing with a decline in sales.  Suggesting an economic recession as everyone is paying their bills slower.

So what could explain this?  A Keynesian stimulus.  Such as those checks sent out by George W. Bush to stimulate economic activity.  Which they did.  Explaining this sales surge.  But a Keynesian stimulus is only temporary.  Once that money is spent things go right back to where they were before the stimulus.  Unfortunately, this business owner thought the stimulus resulted in real economic activity and invested to expand the business.  Leaving this owner with excess production, bulging inventories, aging accounts receivable and a disappearing cash balance.  And a current ratio trending towards insolvency.  Which is why Keynesian stimulus spending does not work.  Most businesses know it is temporary and don’t hire or expand during this economic ‘pump priming’.  While those that do risk insolvency.  And bankruptcy.

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Accounting Shenanigans

Posted by PITHOCRATES - August 13th, 2012

Economics 101

Two Important Accounting Principles are the Realization Principle and the Matching Principle

Accounting isn’t exciting.  It’s dull.  And tedious.  Anyone who struggled to get a trial balance to balance knows this well.  But accounting is a necessary tedious.  Someone has to put those numbers into the proper accounts.  Correctly.  Down to the penny.  Because only then can you prepare financial statements that are useful to business owners.  As well as investors.

When we post these numbers correctly we can produce the income statement.  Or as some call it the profit and loss statement.  Or P&L.   Which tells you whether you made a profit or a loss for an accounting period.  And some of the most important accounts on the income statement are income accounts (or revenue accounts).  The money they get when they sell their goods or services.  And expense accounts.  But not all expense accounts.  They’re all important but some are particularly important.  The expenses used to specifically generate that revenue (the cost of sales).  Production labor.  Production material.  The labor and material that make the things a business sells.  These expenses are variable.  They go up and down with sales.  As opposed to fixed overhead.  Which remains the same regardless of sales.

We have to define the accounting period carefully.  It can be annually.  Quarterly.  Even monthly.  The smaller the period the more useful information for business owners.  Investors study a company’s quarterly statements.  As well as annual statements.  The shorter the accounting period, though, the more careful the posting to the accounts is.  Because of two accounting principles.  The Realization Principle.  And the Matching Principle.   Which places revenue into the accounting period it occurs.  And then matches the expenses to the revenue it created into the same accounting period.  So when you subtract expenses from revenue in that accounting period you get the gross profit for that accounting period.  Given a measure of how business was during that accounting period.  If business was good there is revenue remaining after subtracting all variable expenses and all fixed expenses.  If sales are down there may be a gross profit.  But there may not be enough left over to pay the fixed overhead costs.  Resulting in a business loss.  For that accounting period.

The Smaller the Accounting Period the Greater the Math required to apportion Revenues and Expenses

When businesses ‘cook’ their books they are making business results look differently from what they actually are.  Perhaps the most common way to ‘cook’ the books is to violate the Realization Principle and Matching Principle.  Such as moving revenue or expenses to other accounting periods instead of where they belong.  If a business needs better business results for investors they may realize revenue early.  Or push expenses out to a subsequent accounting period.  Thereby increasing profitability for the one period better than it actually is.  As revenue will be greater and expenses will be smaller.

As an example consider a now common summer business model.  Selling ice-cold water at traffic intersections.  You need some cases of bottled water.  Ice.  And a cooler.  If you buy all the water in July but sell some of it in August you have to split the expense of the water between these two months.  If you don’t your expenses will exceed your revenue in July because it includes water purchased for both July and August.  You would subtract two months of water expense from one month of water sales.  Making July business show an operating loss.  While August would subtract no water expense from August sales making August more profitable than it actually was.  However, if you combine the two months together there will be no misrepresentation of the accounting data.  As you would subtract two months of water expenses from two months of water revenue.

This is why larger accounting periods are easier to post.  As they get smaller you have to do a lot of math to apportion these revenues and expenses into the proper accounting periods.  And sometimes mistakes happen.  Honest mistakes.  A business could have felt they had a good month but their income statement shows a loss.  Or the month could be far better than you feel it should be.  If you look hard enough you can often find a timing error.  Revenues or expenses appearing in the wrong period.  Such as recording a down payment as revenue.  It’s not.  A down payment is a liability.  Because it is a prepayment for you something owe someone at a later date.  And it’s at that later date when you can realize that down payment as revenue.

As you Pull Revenue Up and Push Expenses Out each Subsequent Accounting Period Starts with a Larger Operating Loss

But some businesses cook their books.  And once they start it becomes more difficult with every accounting period.  Which is why most companies that do cook their books fail.  And they fail big.  Here’s why.  If you realize revenue early in this period instead of next period (where it belongs) the following accounting period will underreport revenue.  Worse, the expenses to produce that revenue are still in that period.  When you subtract the properly reported expenses from the underreported revenue it will result in an operating loss.  Unless they cook the books in the following period, too.  By pulling revenue into that period from another period.  Or pushing out expenses to a later period.

The problem is when you keep doing this it makes the following accounting period more difficult to ‘fix’.  For as you pull revenue up and push expenses out each subsequent accounting period starts with a larger operating loss.  And if a business is having problems (which they typically do when they start cooking their books) actual revenue for that period will be depressed as well.  So as they go through subsequent accounting periods beginning operating deficits grow larger in the face of falling revenues.  To keep the scam going they have to take it up a notch.  Taking things ‘off balance sheet’ (basically ignoring some bad financial information).  Creating a shell company to dump bad financial data on.  And other accounting shenanigans.  The bigger the scam, though, the harder the fall.  And there is always a fall.  Think Enron.  And WorldCom.

But it’s just not businesses that cook their books.  Government does, too.  Especially when they want to pass unpopular and costly programs.  They will send the financial data for a program to the Congressional Budget Office to score.  To determine the cost over a 10 year period.  But to make the program less expensive and more palatable to the taxpayers they will cook that data.  Their bill may include new taxes over the ten year period.  But benefits may kick in a few years after the new taxes start.  So you may have 10 years of taxes paying for only 8 years of benefits.  But everyone thinks it’s 10 years of benefits.  Making the program appear less costly than it actually is.  Of course when they get caught in their accounting shenanigans nothing happens.  They just say, “Oops.  We goofed.  Shucks.  Looks like we’ll have to raise taxes.”  Not quite the same thing that happens in the private sector.  Just ask those who were running Enron.  And WorldCom.

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Capital and Capitalism

Posted by PITHOCRATES - May 7th, 2012

Economics 101

Entrepreneurs have an Insatiable Desire to Think and Create

It takes money to make money.  For it is money that buys the means of production.  The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things.  The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods.  These physical assets are capital.  From assembly lines to inventory control systems to accounting software.  Things that let businesses conduct business.  And make profits.

This is the key to capitalism.  Profits.  It’s what allows businesses to make the things we need and enjoy.  Profits are what make an entrepreneur take a risk.  To spend their life savings.  To mortgage their home.  To borrow from a bank.  They do these things because they believe they will be able to earn enough profits to replenish their life savings.  To make their mortgage payments.  To repay their loans.  AND to earn a living in the process.  It is a risky endeavor.  And far more risky than working for someone and earning a steady paycheck.  But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane.  All of which were brought to us because one person had an idea.  And then invested in the capital to bring that idea to market.

Some business ideas succeed.  Many more fail.  But people keep trying.  Because of that insatiable desire to think and create.  And the ability to earn profits to pay for their ideas.  To build on their ideas.  To expand their ideas.  From the first thoughts of it they kicked around in their head.  To the multinational corporations their ideas grew into.  All made possible by the profits they earned.  The more they earned the more they could do.  As they reinvested those earnings into their businesses.  To buy more capital.  That allowed them to build more things.  And use even more capital to bring these things to market.  Creating jobs all along the way.  Jobs that only came into being because of those profits that started as a single thought in someone’s head.

If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy

This is where corporations come from.  From a single thought.  Profitable business operations grow that thought into the corporations they become.  For corporations are not the evil spawn of the damned.  Corporations come from people having a great idea.  Like Starbucks.  And Ben and Jerry’s.  Who are now everywhere so we can enjoy their products wherever we are.  All made possible by the profits of capitalism.

Who’s up for a little accounting?  You are?  Well, then, you came to the right place.  For we’re going to learn a little accounting.  Right here.  Right now.  Corporations determine their profits by closing their books at the end of an accounting period.  A series of accounting steps culminate in the trial balance.  Where the sum of all debits equal the sum of all credits.  Or eventually do after various adjusting entries.  Once they do the books are balanced.  And business at last can see if they were profitable.  By producing an income statement.  Which lists revenue at the top.  Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue.  Subtracting these costs from revenue gives you gross profit.  Then comes overhead costs.  Fixed costs.  Like rent and utilities.  And overhead labor (corporate officers, management, accounting, human resources, etc.).  They sum these and subtract them from gross profit.  Which brings us to earnings before interest and taxes (EBIT).  A very important profitability number.  For if there is any money left by the time you reach EBIT your business operations were profitable.  Your business was able to pay all the due bills to produce your revenue.  Which leaves just two numbers.  Interest they owe on their loans.  And income taxes.

EBIT is a very important number.  For if it’s not large enough to service your debt everything above EBIT is for naught.  Because if you can’t service your debt your creditors can and will force you into bankruptcy.  Never a good thing.  And what follows is usually the opposite of growing your business.  Shrinking your business.  By seriously cutting costs (i.e., massive layoffs).  And eliminating unprofitable lines of revenue.  Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services.  A price determined by your competition in the market.  If you cannot downsize and reorganize sufficiently to become profitable then you go out of business.  Or you sell the business to someone who can make a profit.  Because unless you can turn a profit your business will consume money.  And that money has to come from somewhere.  Typically it is the business owner until they run out of life savings and home to mortgage.  Because a bank can’t give you money to lose in your business.  For their depositors put their money into the bank to grow their savings.  Not to shrink them.  So a bank has to be profitable to please their depositors.  And if the bank is using their money to make bad loans they will remove their money.  As will other depositors.  Perhaps creating a run on the bank.  And causing the bank to fail.  So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term.  Which isn’t good for anyone.

Capitalism works because with Risk there’s Reward

As you can see getting those accounting reports to fairly state the profitability of a business is crucial.  For it’s the only way a business knows if it can pay its bills.  And the way they pay their bills complicate matters.  Revenue and costs come in at different times.  To bring order to this chaos businesses use accrual accounting.  Which includes two very important rules.  To record accurately when revenue is revenue (for example, a down payment is not revenue.  It’s a liability a business owes the customer until the sale transaction is complete).  And to match costs to revenue.  Meaning that every cost a business incurred producing a sale is matched to that sale.  Even long-term fixed assets like buildings and machinery.  Which they depreciate over the life of the asset.  Charging a depreciation expense each accounting period until the asset is fully depreciated.

Because of these accounting reports that fairly state business operations a business knows if they are profitable.  That they can pay all of their bills.  Their suppliers AND their employees.  Their health insurance AND their payroll taxes.  The interest on their debt AND their income taxes.  They can pay all of these when they come due.  And not run out of money when other bills come due.  Which is why they can have confidence when they read their income statement.  Knowing that they paid all their costs due in that accounting period.  Including the interest on their debt.  And their income taxes.  Which takes them to the bottom line.  Net profit.  And if it’s positive they have money to reinvest into their business.  To expand operations.  To increase sales revenue.  Create more jobs.  And they can grow.  But not too much that they lose control.  So they can always pay their bills.  So they can keep doing what they love.  Thinking.  And bringing new ideas to market.

This is capitalism.  Where people take risks.  In hopes of making profits.  They invest in capital to make those profits.  And then use those profits to invest in capital.  It works because there is a direct relationship between risk and profits.  It’s why people take risks.  Create jobs.  And provide the things we need and enjoy.  Because with risk there’s reward.  And accounting reports that fairly state business operations give a business’ management the tools to be profitable.  By matching costs to revenue.  Telling them when they are not using their capital efficiently.  Helping them to stay profitable.  (Unlike anything the government runs.  Because there is no matching of costs to revenue.  Taxes come into the treasury and the treasury pays for a multitude of things.  With no way to know if they are using those taxes efficiently).  And this is capitalism.  Risk and reward.  And accountability.  For when you’re risking your money you become very accountable.  Which is why capitalism works .  And government-run entities don’t.

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