Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). The most useful comparison when performing financial ratio analysis is trend analysis. Financial ratios are derived from the three financial statements; Balance Sheet, Income Statement and Statement of Cash Flows.
Financial ratios are used in Flash Reports to measure and improve the financial performance of a company on a weekly basis.
Financial Ratio Categories
The following five (5) major financial ratio categories are included in this list.
Liquidity Ratios
Activity Ratios
Debt Ratios
Profitability Ratios
Market Ratios
Liquidity Ratios
Liquidity ratios measure whether there will be enough cash to pay vendors and creditors of the company. Some examples of liquidity ratios include the following:
The profitability ratios measure the profitability and efficiency in how the company deploys assets to generate a profit. Some examples of profitability ratios include the following:
Every company has them…past due and slow pay accounts. Here are some ways to help keep your cash coming in the door and collect accounts receivables.
Improve Accounts Receivable Collection and Invoicing
Commercial and industrial experience has proven the following percentages… Of ten new customers, six will pay on time, two will pay in 60 to 90 days and two will become collection problems.
Always watch your new sales. As money becomes tighter, you will receive one-time sales from firms that may be experiencing financial problems. While these customers will bounce from business to business, they need your close attention if you want to retain them. A useful management tool for collecting accounts receivable is the Flash Report.
Credit
Be familiar with your customers’ credit. Only extend credit to organizations you feel confident will pay you. Make sure you don’t have to write off your hard earned sales through bad debt!
Pay close attention to the credit termsyou are offering your customers. One good way to collect accounts receivable (ar) is to do so before you deliver your product and structure your terms accordingly. An example of this would be a propane company in the winter months; nothing works better than to be paid prior to delivery.
50% before work begins, 40% before delivery and 10% after delivery
For wholesalers and retailers:
Depending on creditworthiness, 10 days net for companies with good credit, prior to delivery for companies with questionable credit or those that are past due.
Develop a minimum sales order that will require a credit check
Check three references on a new client
If payment history is greater than 60 days obtain supervisor approval
Perform the following steps when invoicing the customer:
Invoice within 24 to 48 hours after performing service
Assign Responsibility for Accounts Receivable Collections
Use a dedicated collections individual. Then designate one person in your organization to be the accounts receivable collections representative, someone who can make the collection calls and stay on top of accounts receivable. There are some personality traits that you should look for when assigning this function. Some traits to look for: A professional presence, adept at working with and handling difficult people, skilled at follow up and well organized in order to document collection efforts.
You may want to pay your accounts receivable collections individual a commission as an incentive to keep accounts receivable collections current. Alternatively, you might consider paying a bonus at certain increments based on established criteria.
The goal is to work with delinquent companies and receive payment as quickly and cost effectively as possible!
For many companies, add accounts receivable collections to a current employee’s responsibilities as it should not be a full time commitment. If there is a legitimate reason the customer has not paid, then it’s best to get this taken care of early so as not to impact your cash flow for any longer than necessary. Never underestimate the impact of reminder and collection calls!
Accounts Receivable (AR) Collection by Telephone
Given the use of voice mail the effectiveness of phone calls are somewhat diminished. However, they are still an effective means of collection. The phone calls enable the credit manager to present their case to the debtor for immediate response. During the conversation you can determine whether the claim will be paid in full and when. This is the time to determine the reasons for non-payment.
We have put together the following three main reasons for non-payment:
Lack of funds. Most non-payments result from lack of funds.
Dispute. Discuss disputes to determine whether or not they are valid. Adjust the valid claim quickly and fairly, the non-valid claim exposed and immediate payment requested.
Refusal to pay. If it is refusal to pay, you must take third-party steps to enforce payment. Consider hiring a collections attorney.
Check out the following tips on phone collections:
To quote Peter Drucker: You can’t manage it if you don’t measure it! The same holds true for collecting accounts receivable! So how do you measure your effectiveness in collecting accounts receivable?
Daily Sales Outstanding (DSO)
What is DSO?
DSO is the average of your accounts receivable. The numerical accuracy of the number is not as important as the trend. But blend an estimate of how long it takes to collect your accounts receivable. If you are making progress then it should be trending lower. First, calculate where you are today.
DSO = 365/ (Annual Credit Sales/ Average Accounts Receivable)
Commercial Collection Servicies
Hire a collection agency. Ways to find a reputable collection agency include referrals from other companies as well as professional firms and organizations with which your company does business. No matter how you receive the referral, be sure to ask the collection agency for customer references and call the references. Ask some of the following questions:
How responsive is the collection agency to your questions?
Do you have a report on the progress of your accounts promptly and in a format that is user friendly?
Do they remit proceeds quickly and accurately?
Can you resolve these issues quickly?
Final Comments
Review your internal process. Remember, collecting accounts receivable is an internal process as well! Before initiating collection calls, be sure your internal house is in order. It is vitally important that your cash applications are timely and done correctly. It’s extremely embarrassing and inefficient when you run into the following situation. Your collections representative conducts a collection call only to find that the customer has in fact paid the bill and the payment has been misapplied. Furthermore, a similar situation also exists when your employee makes a collection call when the payment was received 2 weeks earlier.
Accounts Receivable Collections
AR Collections should start with your cash applications function. Remember, your process here is critical. So follow it without exception. Further more, apply payments quickly and accurately. If you cannot identify a payment to an invoice, then call the customer in a timely manner to identify what is being paid. This is absolutely critical!
Issue invoices that make cash application quick and easy. If you have large volumes of invoices or are short staffed, automate this process. Then, have an organized and mechanical follow up of accounts at regular intervals in your systems. For instance, use 10,30 and 60 days past due.
Any program that permits three statements or a two to three month time lag before the first collection step is taken will result in a lower recovery ratio. Make collections update meetings a priority for the controller and collections person. At the meeting, review collection notes, progress and next steps.
Know the Cost of Past Due Accounts
If you cover your cash shortfalls with a line of credit, then consider that at an interest rate of 10% on your line, every $100,000 in past due accounts costs you $833 per month or $10,000 per year.
Train Your Customers to be Good Payers
Creating an accounts receivable collection process and following it consistently will allow you to accomplish this important goal.
For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.
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The dreaded “F” word, FACTORING. Now that factoring has been said, I am sure we all are feeling a little more at ease. I was in a meeting recently with a prospect, a Houston based oilfield servicing company, and their CPA whose name was John.
The company was experiencing cash flow problems because of growth. And they have more new business opportunities coming up in the near future. They were trying to determine how to capitalize on these opportunities in their situation of stressed cash flow. The topic of factoring their accounts receivable came up and John said “Only companies about to go broke factor their accounts receivable!” Knowing the CPA profession as I do since I was a CPA earlier in my career, I knew John’s concern was cost. So I had to ask him why he felt that way. He did not disappoint me when he said “factoring is too expensive.” I then told him that I would not normally recommend factoring to any client unless it will make or save them money.
Situations Where Factoring Would Make or Save Money
John then asked me “Tell us some situations where factoring would make or save money.” Knowing that he thought he had me now, I gave him the following examples:
New companies with owner(s) who have verifiable experience within the industry.
Companies with identifiable growth opportunities that have been constrained by an inability to attract adequate growthcapital (cash).
Taken back a bit John still held his ground by saying “It is still to expensive and it will break a company!” Being more perplexed than ever, I told John “Let me explain in terms I think you will understand.”
Let’s say the oilfield service company sells their service for $50 and has a resulting profit of $5. Now let’s say they have an opportunity for more business but do not have the capital (cash) to take on the jobs. So, would you agree they will not make any profits? John reluctantly responded with “Yes”. Let’s say the company has access to the capital (cash) presently locked up in their accounts receivable. Now, they can take advantage of their opportunity in the following manner. They still sell their services for $50 and now have a $3.50 profit instead of a $5 profit. In other words, your client will make $3.50 with me or $0 without me.
Before John had a chance to comment, the business owner said “I like your deal. Factoring can make me money.” Finally, John agreed, and the meeting moved forward.
It is very important for CFOs and financial managers to look at trailing net working capital as a very important Key Performance Indicator (“KPI”). If the trend is for your net working capital to decrease over the last 12 months, quarters or years, this may be an indication of a cash shortage and financial distress situation looming nearby.
Working capital provides very important information about the financial condition of a company for both investors and managements. For investors, it helps them gauge the ability for a company to get through difficult financial periods. Whereas, for management members, it helps them better foresee any financial difficulties that may arise. In conclusion, it is very important for a company to keep enough working capital to handle any unpredictable difficulties.
The term, restructuring expenses,is also a footnote in the financial statements that describes the details relevant to the restructuring charges. These charges often include cash costs, accrued liabilities, asset write-offs, and employee severance pay due to layoffs. Restructurings may occur during a major reconfiguration of business operations or during a change in upper-level management at a company. One of the most common restructurings of a business is the bankruptcy process. When a business files for bankruptcy, that entire process is a restructuring process and would include expenses for attorneys, financial advisors, trustees and court fees.
Big Bath Charges
Financial statement analysts pay special attention to restructuring charges. This is because they may reflect past or ongoing problems with the company’s business operations or corporate structure. Also, managers have considerable leeway in deciding when to record restructuring charges and what to include in the restructuring charges. Companies then may deliberately report a large restructuring expense to manipulate current earnings. The practice of taking a very large restructuring charge is known as taking a “big bath.” The idea is to take a big hit to earnings in the current period in order to make future period earnings appear more profitable. Big Bath Charges are more common in public corporations than private companies.
Restructuring Charges Example
Bubba is the chief accountant at a middle market food distribution company. Bubba has worked extremely hard to achieve his title and enjoys his work. Recently, Bubba has been notified by the board of directors of his company that they will restructure in the next quarter of operations. The company tasks Bubba with accounting for this reformation. It is Bubba’s job to make sense of all of the restructuring charges that the company experiences in this quarter.
Restructuring Charges Example & Steps
First, Bubba receives the memo that the company will convert the current inventory accounting system to an electronic, RFID (Radio Frequency Identification) based system. Here, the company places a small tag on each boxed order received from suppliers. This will occur by simply adding a tag to each box, a radio frequency signal emitter at the entrances of the distribution warehouse, and software which works as a go-between to this hardware and the company accounting software. This tag, in operations, will automatically read boxes as they enter and exit the distribution warehouse. Based on the tag placed in each box, the system will know what, how many, and when inventory is received and delivered. Once this change has occurred, the company will greatly reduce man-hours once used for processing inventories. Bubba finds invoices which total in the amount of $45,000.
Tracking System
Next, Bubba is notified that the company trucks will be equipped with a GPS (Global Positioning System) tracking system. This will allow the company to know exactly where every single truck is, reducing personal stops and protecting company equipment from theft. This system, from the records Bubba has collected, will cost the company $25,000 for hardware, software, and labor on installation.
Statements
Finally, Bubba prepares company statements. He presents these expenses as incurred, rather than showing a “Big Bath”. This will result in logical financial statements, as well as protecting Bubba’s reputation.
Bubba has completed his project to the satisfaction of the company board of directors. For this project, the board has decided to give Bubba a pay raise due to the quality of his work. It pleases Bubba to hear this. He is happy with how he ended this project.
The balance sheet is a financial statement that shows a company’s financial position at a point in time. The balance sheet format comes in three sections: assets, liabilities, and owners’ equity. The assets represent what the company owns. Then the liabilities represent what the company owes. Finally, the owners’ equity represents shareholder interests in the company. The value of the company’s assets must equal the value of the company’s liabilities plus the value of the owners’ equity.
Balance Sheet Equation
This balance sheet formula forms the basis of the statement which is also known as the accounting equation.
There are four basic financial statements: balance sheets, income statements, statement of cash flows, and statement of owners’ equity. Of the four, the balance sheet, also called the statement of financial position, is the only one that applies to a specific point in time. The others cover financial activity occurring over a period of time. That’s why the balance sheet is considered a “snapshot” of a company’s financial condition. Typically, you prepare the balance sheet’s accounting monthly or quarterly.
The three sections of the balance sheet consist of line items that state the value of each account within that section. There is no universal format for the balance sheet, so each company’s balance sheet will look somewhat different. This makes balance sheet analysis more difficult than with GAAP compliant reports. However, the basic equation shown above must always apply.
Balance Sheet Example
Jake owns an equipment rental company called Equipco. Jake’s company has been steadily growing. Due to this, Jake is interested in receiving a bank loan to finance some additional equipment purchases. He needs to know what his total dollar amount of assets and liabilities are so that he can meet the requirements and preferences of his banker. To do this Jake asks his bookkeeper for the most recent copy of his balance sheet.
Jake is excited to learn that he can qualify for his bank loan. To begin, his total assets value is at an acceptable level. Jake also has enough owners equity to satisfy his bank on the corporate level. Surprisingly, Jake finds that he does not have too many liabilities to qualify. This concern was, as he believed, his major obstacle to earning the loan. According to Jake’s banker, his balance sheet ratios have everything in order to receive his loan. All from one statement!
