As a strategy and finance turnaround consultant, I have worked with many companies in a crisis situation. A business owner’s frantic call for help was usually prompted by a cash flow problem. The company’s bank account was dwindling. They questioned their ability to meet future expenses.
Prior to meeting with the owners I would review the company’s financial statements. The income statement and balance sheet provide vital clues about historical performance. Within a short period of time I can piece together a story about the company—the good, bad and ugly!
Here is where it becomes interesting!
When I speak with the owners, the perceived reason for the crisis is always the same. It was the result of a recent decrease in sales due to some market-driven event, such as a loss of an account, entrance of a new competitor, etc. “If I could simply replace the missing account or gain new business we would be fine,” the business owners would tell me.
However, their financial statements told a different story. While it is true that a drop in sales reduced the company’s available cash, this event exacerbated the situation but did not represent the entire problem. There was a structural issue inherent in the business model, which could include the price charged to customers, cost to produce, amount of overhead or any combination therein.
I am often asked how an underlying structural problem could go unnoticed for so long. The answer from an accounting perspective: the company was surviving on cash reserves from unearned revenue. In simple terms, the company’s positive cash flow balance could have been augmented by deposits received from customers and/or payments not yet made to vendors. With the loss of new sales to cover past expenses, the problem surfaced to a crisis situation.
Back of the Envelope Financial Calculations.
Why did I suspect that the cause of the problem was not only sales related? I examined the balance sheet and did some back of the envelope calculations. Sometimes the calculations would immediately direct me to a problem with the business model. Other times the numbers simply did not make sense; they were not consistent with the income statement. This would alert me to a possible problem with the internal accounting processes.
Incorrect accounting processes are more common in smaller companies due to a lack of financial sophistication. Often the liabilities on the balance sheet are understated. Specifically, customer deposits are considered unearned revenue and should be placed as a liability on the balance sheet. Incurred vendor bills and/or salaries should be as well. If the company accepts deposits and/or incurs vendor bills these accounts should be on the balance sheet.
If the accounts are not listed or the numbers simply do not make sense, it can be a red flag for another possible problem. The income statement may be incorrect. The company may not be as profitable as perceived to be. I have just opened Pandora’s Box!
What does this all mean?
In simple financial terms, the profit obtained from the sale of their product or service is insufficient to cover the cost of operations and allow adequate financial reserves for reinvestment in the company. The reduction in sales was just the surface of the problem. The underlying financials were not in balance. A cash flow crisis was inevitable.
To solve the problem the company would need to increase the selling price, decrease the cost to produce or cut overhead cost (or a combination of all). Simply adding a new account using the same pricing/cost methodology would not solve the problem.