Financial statements can tell lies

There are three kinds of lies: lies, damned lies and statistics! And might we not add financial statements?

We may not all be accountants but we all rely on what we expect is the proper disclosure of financial information when we assess an opportunity or look to make an investment. Psychologists say we look for familiar patterns. In financial numbers it is no different.

For some of us, these financial patterns will be quite simple (Sales, Profit), for others it will be quite complex (Break even, Return on Investment, Interest Cover). No matter your level of expertise, it is important to recognise that numbers ain t numbers .

In many turnaround assignments, I have been amazed that the numbers prepared by businesses and their accountants are not what they seem often not due to any obvious dishonesty but perhaps less than rigorous analysis of what the numbers should be trying to convey.

Perhaps all businesses have the same problem but they only come to a head when money is scarce.

Numbers must be understandable and sensible from the perspective of the users not the accountants who prepared them. They are designed to assist management understand whether their business is making a profit or loss and to determine key issues like Which products are profitable to produce? and What sell price do we need to be profitable and competitive? .

Now for some examples first the Profit & Loss

Sales

Surely a simple number which cannot lie ? Let s see.

Case Studies Examples

At Sugar Co. (confidential case study), the Sales to some retailers were shown gross of rebates, some were shown net, some rebates included the retailer s credit term discounts, others didn t. In other words, direct comparison of Sales (and margins) between customers was impossible. Each of the 3 major retailers had vastly different rebate structures, ranging from 2.5% for private label products (i.e. house brand) sales to 24.0% for proprietary label products.

To make matters worse, it was difficult to enter the retailers rebate data into our systems in a consistent manner as each retailer required us to show different information on our invoice, depending on whether the information was being seen by Head Office or the Retail Stores. In a big picture sense this would not cause a problem. However, when comparing contribution by product and margins, it caused all sorts of incorrect conclusions. And, imagine trying to explain this to sales staff who are not financially inclined ..

Costs of Sale

This one can be a real doozy! As these costs directly impacts upon the Gross Margin, any calculations you make based upon what is included or excluded directly impacts Gross Margin dollar and percentage calculations.

Case Studies Examples

At Sugar Co. there seemed no logic as to why some costs were included as Costs of Sale and some were included as Overheads. Rent was a Cost of Sale, electricity (fairly variable with a manufacturing company) was an Overhead, some operational labour was costed into the product but some was excluded.

After much analysis and review, we made the costings consistent and essentially variable in nature (i.e. tied to the quantity produced). The resulting margins saw large changes to the costs of each product and the margins being achieved.

Getting the allocation right had a big impact on our production mix, our pricing and our future direction.

At Capital Equipment Co. (confidential case study), we made complex, large machines with low margins (sounds like a problem right there!) which had long lead times for completion (over 30 weeks when I arrived).

The cost of funds was therefore a critical cost for this business. Once factored into the profitability of a machine, we changed pricing on some products, focused on reducing production lead times (achieved 16 weeks), and altered our sales mix focus.

Overheads

Expenses either end up as a Cost of Sale or an Overhead, so, as note above, the cost allocation between the two can be a problem if the split is nonsensical. Overheads can also mislead in their presentation.

Accountants with green visors like an A to Z approach. First are the A s – A: Accounting fees, then Advertising then B for Bank fees, you get the idea. There is no attempt to group costs by function or value add . Which leads me to .

Employee costs

As one of the largest costs of most businesses, I always like to see this cost presented by department Sales, Marketing, Operations etc and even have sub categories when it makes sense. It also helps to include all costs for an employee their Wages, (a W ), Commissions (a C ), Superannuation (an S), phones (a P ) plus their other costs. (Did you know that if your blended workers compensation rate for your whole business is say, 4%, your rate for manufacturing labour could be as high as 7% (or higher if you have a poor OH&S history) and the sales & admin cost could be as low as 2%?).

Now for the Balance Sheet .

Stock

This is the other side of Cost of Sales and so any misstatement in Costs will also result in a similar misstatement with Stock as well.

Case Studies Examples

At CE Retail (confidential case study), an estimate for inbound freight was included in the Cost of Sales but not in the Stock figure figure that one out!

At Sugar Co., I found we had a constant Work in Progress figure each month, the logic being that there was always the same amount of product in WIP at any one point in time. This assumption proved to be incorrect. It varied quite considerably depending upon the season and what was being produced. (When we did an independent stocktake & valuation (always a good idea for a new CEO in a troubled business), the value of WIP miraculously decreased by $0.5M and up went our losses by the same amount.

In another example at Sugar Co., we had lots of packaging stock the only problem being much of it was only useful for products we no longer produced.

In an insolvent situation, the balance sheet value of stock can get even more dicey as there are issues such as retention of title (everyone has an ROT clause these days it s just a pity they aren t all drafted as well as they should be that s a hint for lawyers!).

In CE Retail, floor plan stock was shown as an asset with the associated floor plan debt shown as a creditor. The difference between the two values increased the underlying value of the balance sheet. Unfortunately, the way floor plan stock works, the business does not own it until it is sold so the business would never have the benefit of this difference in the value of the asset and liability.

This treatment of floor plan stock overstated the balance sheet by around $300K and made a marginal balance sheet look far stronger than it actually was.

Debtors

A sale is only a sale when the cash is collected. With debtors, it looks temptingly like cash but often this can be an illusion.

Case Studies Examples

At Sugar Co, we had special rebates due back to one of the major retailers which was shown in our accounts as a liability. Without warning, the retailer offset their debt owing to us against the amount they were owed. That s ok when cash is plentiful but not so good when cash is tightly watched and suddenly your expected cashflow from debtors has a hole in it.

A debtor who does not pay is worth zip to your business. At CE Retail, we had over 25% of the debtor book claiming all sorts of things due to poor service and it was always the same customers! Admittedly, prior to our arrival, procedures were so loose that these squirming customers had plenty of room to move.

If your business deals in a close knit industry, the chances are some suppliers are also debtors. Try collecting from them when you are not paying your bills on time! That s a good way to see debtors evaporate into thin air and a balance sheet change complexion overnight. At CE Retail, our largest debtor was also our largest creditor and when the balance sheet was re-jigged for set off of these debts, it changed shape remarkably and not in a good way either.

Creditors

This can be an area of misstatement, particularly in accruals, unpaid taxes and contingent claims.

Case Studies Examples

At CE Retail, no accrual mechanism was in place for stock received without an invoice how they would have tracked down the stock if it had gone missing I have no idea, but it also meant that it was more tricky to reconcile what we owed against what the creditor thought we owed.

Many businesses have not completed up to date BAS returns and so the tax debt is understated. Everything looks to be ok until you actually look at the date of the last return prepared and lodged. Solution? Don t just ask, have a look for yourself.

Provisions

Provisions for Annual Leave, Depreciation etc are not updated regularly, understating liabilities and overstating profits. This is always a source of under-recorded liabilities and sometimes the amount can be very large.

Unrecorded contingent claims

Case Studies Examples

At Sugar Co., a supplier had taken legal action for non payment of a debt which Sugar Co. had been claiming was not due as we had received faulty product. Unfortunately for Sugar Co., our record keeping on the faulty product issue was less than stellar and so was out ability to defend the claim.

Debt

This is a hard one to get wrong but here are a couple of examples with a difference.

Case Studies Examples

At Sugar Co., the level of debt had risen far beyond the approved 75% lending ratio (it was an invoice discounting facility against the value of book debts). How? Well, if you give your financier incorrect debtors figures, anything is possible!

It s not the debt but the capacity to borrow which is often the key. When looking at an overdraft or other debt facility, understand whether it has been fully drawn down and if not, what additional capacity is available. This difference is not shown on any balance sheet but is critical when assessing the future cashflow of the business.

Fixed Assets

With operational leases, financial leases, $1 purchase options etc, this has become a minefield when assessing the real value of fixed assets.

Case Studies Examples

At CE Retail, a couple of the financiers thought they were well covered by the fixed assets until we calculated that most of the value on the balance sheet related to leased assets as well as those owned assets called leasehold improvements (very difficult to realise when you lease the premises).

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