A Unique Approach to Analyzing Your Financials from High School Science

An email comes in from a client, and he’s asking for my help. He wants to understand where his money is. Why did he just have to infuse his company with $15,000? Is he not profitable? If he is profitable, where is the money?

When I was in high school science class I learned the scientific method.

• Write out the problem
• Form a hypothesis
• Run some tests
• Draw your conclusions

The problem as my client e-mailed me, is simple.

Where is my client’s money?

My hypotheses:

• Profits decreased
• Cash is tied up in accounts receivable
• Cash is tied up in inventory
• Cash was drawn out of the business

By forming hypotheses, you are setting an expectation about what MIGHT be the cause. This gives you a gauge for when something doesn’t look right. If you know what you are expecting to see, and then you see something different, your natural instinct will be to pause.

The test:

Analyze the profit and loss and the balance sheet.

Have profits decreased?

I checked his profit and loss statement. I always run them totaled by month. This allows me to analyze trends and make sure things line up correctly. There are certain things to look for. What is the revenue trend? If the revenue decreased in the last couple of months, then COGS (Cost of Goods Sold) should decrease proportionately. I usually scan right down to the net income, so I understand that trend first. Then in the months that decreased, I go straight back up to revenues. Did revenues drop? If they are about in line with prior months, then it’s a matter of seeing what expenses increased and understanding why.

In my client’s case, the revenues dropped a bit in the last two months, but not enough to cause such a drain in his cash flow.

Is his cash tied up in accounts receivable?

This may partially explain the issue, but not entirely. The accounts receivable (A/R) balance has increased every single month this year to date. This is a problem that needs to be addressed, but it isn’t enough to explain why he had to contribute $15K.

It’s important not to only analyze what the accounts receivable balance is. It may be perfectly normal to have $150K in A/R. If it stays around that amount, it means that A/R is turning over. This would not explain a shortening in cash flow.

It’s the CHANGE to accounts receivable that counts here. That is what I analyzed above.

Is cash tied up in inventory?

Looking at this inventory, there is almost $700,000, and almost every single month represents an increase over the prior month. This is a big problem. A closer look at the balance sheet also reveals that they have an additional $120K in “pre-paid” inventory.

Conclusions:

1. Did profits decrease? Cash flow did not tighten up from a decrease in profits.
2. Is cash tied up in accounts receivable? Steady monthly increases to AR may partially explain the tightening in cash flow.
3. Is cash tied up in inventory? Inventory is definitely the area of greatest concern. There is too much money tied up in here. The next step is to analyze what is sitting in inventory that hasn’t sold in a while. We need to come up with some promotions to help move that inventory. Maybe send a newsletter to our list reviving interest in those items, as well as announcing the sale we’re going to do.
4. Was cash drawn out of the business? Without having to do much research, I already knew the client hasn’t been pulling money out of the business. He takes a regular salary from the business and that hasn’t changed.

The outline above is a great way to approach the solution to any problem you are having in your business. It helps you stay focused so you can actually arrive at the root cause of your problem and itemize the solution in your conclusions. The conclusion might be that you need more research, as is the case right here, but now we know exactly where to look and what to look for. My aim next is to analyze each item in the client’s item list and get a summary by item of monthly sales and current inventory in stock. We want to see what is sitting in inventory that hasn’t sold. We certainly shouldn’t be buying any more of those but we also want to look at ways to get that inventory sold!