Three-Factor Analysis

I bumped into Dan Brown at a ballgame. Dan is a partner in Manchester Consulting Engineers, a firm with 40 professional staff. When I asked how things were going, Dan said, “I feel like it’s the best of times and the worst of times.”

“I don’t understand.”

“Our profits are fine, but I’m worried. the bank wrote us a letter last week telling us that they are going to limit the amount they loan against our receivables.”

“That’s ominous.”

“Exactly. And it comes at a time when our profits are at an all time high.”

“Have you talked to your banker?”

“That’s a bit of a problem. We have a management committee now, and I don’t want to step on their toes.

“Why don’t you send me a copy of your financial reports from the last couple of years. I’ll review them and then we can talk.”

“This will be confidential just between the two of us?”

“Of course,” I said.

“I’ll have them delivered to your office.”

As soon as the financial statements arrived, I performed a three-factor analysis. The analysis traced profitability, return on investment and cash flow over the years from 2000 to 2003. I discovered that the company’s profits had grown by about 5% per year. That led to a strong balance sheet because Manchester had a tradition of retaining 20% of its after tax profits to fund growth.

On the negative side, although the dollar value of profits rose, the company’s profit margin declined. The decline disturbed me because profit margin (profit/sales) is a measure of production efficiency. So despite its increase in accumulated profits, Manchester had not been able to maintain its historic profitability levels. In other words, the company had become less efficient at converting sales dollars into profits.

Next, I examined the company’s cash flow. Manchester’s cash flow differed from profit mostly as a result of an increase in receivables and work-in-process (WIP). For example in 2003, Manchester earned a profit of $7 million. In the same year, its receivables increased by a significant 13% and its WIP increased by 11%.

However, when I arrived at Dan’s office to discuss my findings, he was smiling from ear to ear. “You look like the cat that’s eaten the canary,” I said.

“Our old bank manager has been transferred. The new guy has no problems with us — and the finance committee has declared a special dividend to the senior shareholders. We’re all feeling pretty good.”

“That’s great,” I said. “I’m happy for you, but I think your earlier concerns were warranted. My analysis showed that Manchester’s performance has eroded. In particular I’m worried about your receivables collection and your WIP turnover.”

Dan motioned for me to sit down and said, “Explain.”

“The company has become slower to collect what’s it’s owed. That increases your reliance on bank debt and interest costs, which is unfortunate Even worse, it will likely lead to greater write-offs.”

“What can we do?”

“First you should review your collection procedures and make a serious effort to collect what’s owed you within 30 days. Second, consider your sales approach. You may be taking on jobs that are higher risk in order to boost sales. That can lead to problems. When an economic turndown comes, you may be setting yourself up for some big losses.”

“You also mentioned WIP.”

“That’s a major problem. Over the last couple of years, your WIP balances have grown. You are paying for WIP right away — that’s where your salaries go. But the company has become slower at converting WIP to receivables.”

“I’m not sure why that’s happening.”

“It can be a result of your increased capital base and your capacity to borrow to pay your bills. Your procedures may have become sloppy because you had alternative sources of cash.”

“Do you think that’s what the banker picked up on?”

“Possibly. Manchester’s financial success may have allowed you to lose focus.”

“So you’re against our increasing our debt?” asked Dan.

“I’d rather see you develop a stronger discipline for converting WIP into receivables and then cash. For example, I notice that three years ago your WIP turnover into accounts receivable over the year was 10 times. Now it’s down to nearly eight times. A drop in WIP turnover like this has an enormous impact on cash flow.

“I’m not sure I follow.”

“Three years ago your WIP was worth $1 million and you billed $10 million. That means that each month you built up cash flow of about $830,000 ($10 million/12 months = $830,000) and you billed that amount. But now your billings are $12 million and your WIP has grown to $1.4 million.”

“Doesn’t that make sense?” Dan asked. “The increase is almost proportionate.”

“Not quite. You are now turning your WIP over 8.5 times per year. In other words, your company procedures have become slower at converting WIP to receivables. That’s why you need to borrow. When you borrow, your operating costs rise because of interest expenses. And when you’re slow at converting WIP to receivables, your bad debts rise. For the present, you’ve been able to cover up the consequences of your decline in efficiency by borrowing — but borrowing your way out of your problems is not a long-term solution. The real solution is to become more efficient.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto, e-mail: hbulmash@bulmashcullemore.com