ACCOUNTING

How to Spot Trouble in Your Financials

Diagnose what's wrong with your company by zeroing in on your financials.

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In mere minutes Jerry White can usually diagnose what's wrong with a company -- often to the shock of the clueless entrepreneur. That's because White, a professor at Southern Methodist University's business school, knows where bodies tend to be buried, at least financially speaking. Here's where.

If your problem is paying the bills: This is an easy one. You need to calculate your Current Ratio:

Current Assets / Current Liabilities

Current Assets is the sum of your Cash, Accounts Receivable, Inventory, and Prepaid Insurance. Current Liabilities is the sum of your Accounts Payable and Accrued Expenses Payable. Do the math for this example [1,903,575 / 657,500 = 2.8], and you end up with a ratio of roughly 3 to 1 assets to debts. Your goal should be a healthy 2-to-1 ratio. Acme is in great shape.

If your problem is debt: As any homeowner knows, debt isn't a bad thing. But it can be risky. To see where you stand, calculate the following:

Debt-to-Assets Ratio = Total Liabilities / Total Assets

Acme is not overleveraged. Its debt ratio is 0.35 [1,152,500 / 3,333,575], which means it has a fair number of assets relative to its debt. If that number were more like 0.5, one might have reason to worry.

If your problem is slow-moving inventory: Is your warehouse a tad sleepy? To find out, figure out your Average Inventory Turnover and your Daily Turnover:

Inventory Turnover = COGS / Ending Inventory

or

Daily Average = Ending Inventory / (COGS / 365)

Acme manages to turn over goods three times [3,000,000 / 900,000] a year or every 110 days [900,000 / (3,000,000 / 365)]. So is that good or bad? Performing the same calculation for Acme for the previous two years reveals a slide. Its inventory turned five times in 2001 (every 69 days) and four times in 2002 (every 85 days). Somebody needs to kick a little butt.

If your problem is collections: Collections suggests a variety of issues from how good your product is to whether your customer service department needs help. You want to see a high Turnover Rate and a comparatively low Collection Period.

Accounts Receivable Turnover Rate = Sales / Accounts Receivable. Divide 365 by the Turnover Rate, and that is your Collection Period (the number of days it takes to collect on a bill).

Acme's Collection Period is 87 days [365 / (4,000,000 / 950,000)]; 30 days is ideal. And look at the historical numbers: In 2002, collections were just as slow, but back in 2001, the company was typically paid in about 40 days' time. This is a definite red flag.

If your problem is you're screwed: The Gross Profit line (here, $1 million) may lead you to believe that this business is making mad cash. Wrong! Net Income matters so much more. If it's negative that basically tells you how fast you are consuming your cash reserves. Compare Net Income to Cash (that top line on the balance sheet) and any personal reserves you have (stocks? bonds? unclaimed Lotto tickets?) to see how long you can run at this rate before, well, bankruptcy. Acme burned through $213,195 in 2003, and has little more than that amount ($233,575) in Cash. If it hasn't improved its inventory turnover and collections by the end of this year, it will very likely run out of money.

Click here to see this problem illustrated in a sample balance sheet.

Click here to see this problem illustrated in a sample income state.

Last updated: Oct 1, 2004

DARREN DAHL

Darren Dahl is a contributing editor at Inc. magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, North Carolina.




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