HAVE YOU EVER sat in your tax accountant's office for your annual review of your tax return and heard this somewhat common good news/bad news story? He'll say the good news is your sales are up and it looks like you've had a great year. The bad news is you don't have any money in the bank and the tax bill is due.
You're not the first and likely won't be the last to experience this dichotomy. Let's see how the owner of a company could have seen the financial heartache coming.
The trick is to know what to look for in the balance sheet. You can generate a balance sheet anytime. However, most companies only produce a balance sheet once a month. Take a look at the balance sheet example on this page. Assets increased and liabilities decreased. Is this company better off today than last year? First, look at the comparison information. This company paid off accounts payable to the tune of $150,000. It purchased trucks for $100,000. In the end, it also had a $90,000 job go uncollected. These transactions brought about several changes on the balance sheet. For example, cash decreased by $500,000, yet accounts receivable increased proportionately. This could be due to granting credit to less qualified customers in order to obtain more work.
There were several other changes as well. Did you notice that inventory remained the same? This is an indication of an uncontrolled inventory system. The amount recorded is most likely plucked out of thin air.
The key point I hope you have seen by now is to train yourself to notice where and why changes occur or don't occur. If you expected a change and don't see it, then investigate why. After reviewing the changes, plug in a few key ratios to see even more.
The first ratio to use is the current ratio. The current ratio is a measure of a company's ability to pay off its current liabilities. This ratio simply composes current assets ($1,200) divided by current liabilities ($825). The current ratio for 10/31/05 is 1.45. The current ratio for 12/31/04 was 1.2. The fact that the current ratio increased is good. However, most banks and financial analysts prefer a current ratio of 2.0 or better.
A variation of the current ratio is the quick ratio. The difference between the two is discovered in the calculation. The quick ratio is calculated by taking the sum of current assets less inventory ($1,200 - $100) and dividing by current liabilities. The quick ratio is 1.33 for 10/31/05 and 1.1 for 12/31/04.
Now, let's see how this company is handling its accounts receivable turnover. This ratio examines the number of times your accounts receivable turns over in a period of time. It is calculated by taking total sales and dividing it by the accounts receivable balance. In this example, sales are $4,000 and accounts receivable $1,000, resulting in accounts receivable turns of more than four times a year. For a service company, the higher the ratio number, the better. A company with an accounts receivable turnover rate of 52 would indicate that it turns its receivables 52 times a year or once every week.
The inverse of this ratio is the collection period. To calculate the collection period, you take accounts receivable ($1,000) and divide it by sales ($4,000), then divide it again by 360 ( representing the days in a year). The collection period for this company is 90 days. This means on average, if you sell something today, in 90 days you will be paid for the sale. For the turnover ratio, a higher number is better. As this is the inverse, a lower number is better for the collection period. For most service contractors, we would like to see a 1.0 ratio, indicating that all sales on average are collected the same day of the sale.
The next ratio, inventory turnover, is very similar to the accounts receivable turnover. It is calculated by taking the material cost of sales (purchases) and dividing by inventory. Just as with the accounts receivable turnover, the higher the number for the inventory turnover, the better. For inventory turnover to be accurate, inventory must be accurate. As we suspected earlier, this company's inventory might not be accurate, so we won't perform the calculation here.
This last balance sheet ratio that I will address is the debt to equity ratio. The measure of a company's net worth compared to its debt is a critical ratio. The higher the debt to equity ratio, the more influence your creditors will have on running your business. A debt to equity ratio of less than 3:1 is considered good.
The debt to equity ratio is calculated by taking the sum of total long-term debt ($300) plus total current liabilities ($ 825) and dividing this sum by equity ($340). For 10/31/05, the debt to equity ratio was 3.3, for 12/31/04 it was 14.7.
Build a habit of looking at your balance sheet on a monthly basis. Look at variances or changes from one date to another or the lack thereof. Learn how to calculate and use the ratios we've presented here. By following this regimen, you shouldn't have any surprises when you visit your accountant at tax time.
Steve Schneider is a business coach for best practices group Nexstar, working with member companies to improve their financials, operations and customer service. A former plumbing contractor and certified public accountant, he has 20-plus years' experience in the service industry. He can be reached at 888/609-5490 or visit www.nexstarnetwork.com