Working on IT Tuesdays Payoff Tools

Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions

FINANCIAL STATEMENT ANALYSIS Questions to ask and Observations to make

Revenues Also known as the following: Sales Revenue, Sales.* Assuming each unit of service/product sold is profitable, the goal is to make revenue go up.

1. What are the long-term trends (year to year)? Going up, going down, flat? 2. What are the short-term trends (month to month)? Going up, going down, flat? 3. Look for the highest and lowest months, and be alert for potential and normal seasonal changes. 4. 5. Are net revenues up, down or the same when compared to the last period? 6. Does the company have seasonal sales level fluctuations? 7. Are the revenue levels normal for this period? 8. Compared to last month, quarter or year, are revenues higher or lower? 9. What internal factors contributed to the revenue levels, e.g. Management, Financial, other? 10. What external factors contributed to revenue levels, e.g. Economic, Competitive, or other? 11. Are revenue levels on track with the Key Strategic Indicators? 12. 13. For revenue targets missed, what changes will you make? 14. For revenue targets made, what changes will you make? 15. What changes do you want to make with respect to sales? 16. If you have individual profit centers, ask the same series of questions above for each.

(*Note: "Net" Revenues equals Gross Sales Revenues minus Returns and Allowances, [generally retailers have returns and allowances.])

Direct Costs Those costs associated directly with the production of revenues.* Usually they include direct labor, materials and sales costs. Assuming all measures have been taken to optimize them, Direct Costs as a percentage of sales should not vary year to year, month to month by more than a couple of percentage points either way (plus or minus.)

1. Are they consistent as a percentage of net revenues when compared to the last period? (should be) 2. If not, which of the direct cost accounts are different that the norm?

3. What are the contributing factors? 4. What could be done to minimize direct costs in the future? 5. Do direct labor costs need to be watched more carefully (output per labor hour?) 6. Do direct materials/goods purchases and waste need to be controlled?

Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions 7. Do sales commissions need to be adjusted? 8. What changes do you want to make with respect to direct costs? 9. If you have individual profit centers, ask the same series of questions above for each.

(*Note: The terms/account types "Variable Costs" and COGS (Cost of Goods Sold) are sometimes used instead of "Direct Costs." However, Direct Costs can be either a Fixed dollar amount or a Variable (percentage.) Variable Costs are costs that 'vary' with the level of sales. While all costs vary with sales levels, some do so much more than others and those that vary highly are included in the variable cost section.)

Gross Profit Revenues minus Direct Costs equals Gross Profit.* Unless prices are raised or direct costs reduced, Gross Profit should also be consistent as a percentage of revenues from month to month and year to year, not varying by more than a few percentage points either way.

1 Is gross profit consistent as a percentage of net revenues when compared to the last period? (should be) 2 In no, are the variable cost changes above causing the variance in the contribution margin percentage? 3 If not, has the pricing changed? 4 If not, have the types of products or services sold changed proportions? 5 If the contribution margin improved by becoming greater, what were the contributing factors? 6 Are Operating Expenses consistently higher than Gross Profit? If so, the client may want to look at improving profitability by reducing Direct Costs, reducing Operating Expenses or raising prices. They are spending more than they are making!) 7 What could be done to maximize the contribution margin in the future? 8 Could prices by raised? 9 Could only certain products or services be sold or emphasized to sell? 10 Could variable costs be managed better so the contribution margin could improve? 11 What changes do you want to make with respect to the contribution margin? 12 If you have individual profit centers, ask the same series of questions above for each.

(*Note: Gross Profit minus Sales Expenses equals "Contribution Margin." Sales and marketing expenses are included under variable costs only to the extent that they are variable such as sales commissions or per prospect marketing costs. Fixed sales and marketing expenses would be included in the fixed expense section of the Profit and Loss Statement.)

Operating Expenses (Fixed Expenses/Overhead/General & Administrative) For our purposes, Operating Expenses can also be referred to as Fixed Expenses, Overhead or General and Administrative Expenses) The dollar amount should remain constant. If Operating Expenses change from month to month, it may indicate that the client has some variable costs (often, direct labor) incorrectly entered into the Operating Expenses section. The client will need to change the Chart of Accounts to more accurately show Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions Variable Costs and Operating Expenses. Or the problem could be that operating expenses simply need more control.

1 Are they consistent as a dollar amount when compared to the last period? (should be) 2 If not, what line item account variance contributed to the increase/decrease? 3 If yes, what line item amounts varied compared to the last period? 4 What fixed expenses pay for items no longer used to produce or support the production of revenues? 5 Can fixed expense accounts be reduced by negotiating such things as leases, phone rates, etc.? 6 What changes do you want to make with respect to fixed expenses?

Operating Expense Ratios (Equal to each line item expressed as a percentage)

1. Check each line item for what percentage the account represents of total revenues. 2. Is anything different than normal? 3. If yes, what do you need to investigate further? 4. What changes will you make as a result of the investigation?

Net Profit Net Profit = Operating Profit plus/minus Non-operating Income and/or Expense, respectively)

Look for the direction of both the dollar amount and the percentage of revenues. Do the same for the long and short-term trend. Be alert for any month or year when revenues were lower and percent of profit was higher. Also, look for the best month and worst month of profit, and ask the client about it. This could indicate some problems with how the client reports revenues and expenses. Or, it may only indicate some seasonal variations in the business.

1 Is net profit up, down or about the same when compared to the last period? 2 Did you sell any property or equipment? 3 Did you pay off debt? 4 Did you pay theself dividends in the form of a draw? 5 What other factors contributed to the net profit change? 6 Is there anything you plan to do differently in the next period? 7 What changes do you want to make with respect to non-operating effects on net profit?

Operating Profit (Operating Profit = Earnings Before Interest and Taxes [EBIT]) This is the same as net profit if the client did not add/subtract money from the net profit of the company for non-operating (not related to day to day operations) transactions such as the sale of an investment, purchase of a boat for personal use, etc.) Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions

1 Is operating profit up, down or the same when compared to the last period? 2 Is operating profit where it could be? 3 Can a plan be created for getting there? 4 What is the industry norm? 5 Is the operating profit percentage within a few percentage points of peer companies? 6 What revenue level would the company need to attain to bring the operating profit dollar amount you would need for financial freedom? 7 What changes do you want to make with respect to operating profit?

Break-even revenues Break-even revenues = Fixed Expenses divided by Contribution Margin expressed as a percentage (%). This is the level of sales revenue whereby all direct costs and fixed expenses are covered. (All fixed expenses are covered by the contribution dollars.)

1. Are you breaking even consistently? 2. Are you taking a loss in some months every year? 3. Are the variable expenses growing? 4. If yes, follow questions above related to variable costs. 5. Have the suppliers raised their prices while the prices remain the same? 6. Are you under pricing some or many of the products/services? 7. Are the fixed expenses growing? 8. If yes, see questions related to fixed expenses above. 9. Did you expense a large purchase in one month rather than financing the purchase over time? 10. What changes could you make to even-out the profitability over the year? 11. What strategies could be used to overcome slow months?

Total Equity or Owners Equity (Total Assets minus Total Liabilities = Total Equity or Owner's Equity) The bank may require a certain amount of equity be present in the business in order to provide loans. The amount of equity an owner has in the business can vary widely. We've all heard the saying, "It takes money to make money."

1 Is the equity in the business increasing or decreasing? 2 For any profits the books are showing, are you able pay some to theself? 3 Are you building equity in the business? 4 Are you building equity in the personal financial plan? 5 What changes to the owner's equity account do you want to make? 6 Has the owner purchased a building which he/she is in turn having their business rent? If so, is it included on the balance sheet? If so, it should be removed.

Current assets (Cash, Accounts Receivable, Inventory)

1 What percentage are cash, accounts receivable, and inventory? 2 Are the percentages different or the same when compared to the last Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions period? 3 What are the factors that caused the change in one or more of the three accounts? 4 Is there too much cash available in a deposit account that could be invested in a money market account or similar short-term interest bearing account? 5 Are the accounts receivable growing, but cash declining? 6 Is the A/R aging different than normal? 7 Do you have a line of credit? 8 Is the balance equal to or greater than the monthly accounts receivable balance? 9 Is the inventory growing, but accounts receivable and cash declining? 10 Do you need to liquidate or donate inventory that hasn't moved in months or years? 11 What changes do you want to make with respect to current assets?

Fixed Assets (Long-term Assets or Property, Plant and Equipment [PP&E])

1 What percentage of fixed assets are property and plant? 2 What percentage of fixed assets is equipment? 3 Have there been any capital improvements or expenditures in the last period? 4 How much equipment is needed to sustain revenues? 5 Of the assets that are equipment, are they fully utilized? 6 At what capacity are they running? 7 How much equipment is needed to reach revenue projections this year? 8 Do you need to consider liquidating some equipment or property that can't be used to create money? 9 How much down time is experienced each day, hour or month? 10 Do you need to upgrade some equipment in order to increase productivity, effectiveness and efficiency? 11 What changes do you want to make with respect to fixed assets?

Current Liabilities (Accounts Payable including the Current portion of Long-term Debt.)

If this number is over 20 to 30 days, it indicates that the business is may have cash flow difficulties, and is losing money in interest charges and late fees. It also makes it more difficult to get a favorable response from a lender.

1 .Do you have a good relationship with the creditors? 2 Are you're A/P aging reports normal for your industry? (some industries allow longer terms for repayment.) 3 When you divide the current assets by the current liabilities do you get a number of 1 or greater? 4 Do you carry an inventory of products or materials prior to selling them? 5 If yes, when you divide cash and accounts receivable by current liabilities do you get a number of 1 or greater? 6 If you calculated 1 or greater for question number 3, but less than 1 for the first question, do you have too much inventory or would you

Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions benefit from longer credit terms with the suppliers? 7 If no, are you paying for labor, materials and other direct expenses before the client pays you? 8 Do you pay the employees every week? Or every two weeks? 9 If you pay the employees every week, could you bill the customers every week? 10 What accounts receivable terms could you offer that would create more of a one-to-one ratio between when you pay and get paid? 11 What changes do you want to make with respect to current liabilities?

Working Capital (Current Assets minus Current Liabilities = Working Capital)

On page 2 of the Financial Controller, look at Working Capital. The higher the better, and the trend should be going up. A good rule of thumb is to have Working Capital equal to a minimum of 2-3 months worth of expenses. Just like in one's personal finances. The riskier the enterprise, the more you'd probably want to set aside.

1. If the company experienced high growth or a major and unexpected turn of events how well could the business withstand the pressure? 2. If you divide current assets by current liabilities do you get a number of 1 or greater? 3. A 1 or greater means that for every dollar in current liabilities the business has 1 dollar or greater to cover liabilities. 4. Do you have an extra month's expenses aside for high growth or a major unexpected turn of events? 5. If not, what would it take to start putting that aside? 6. Do you have inventory that has not moved in years? 7. Can it be liquidated or written off? 8. What changes will you make with respect to working capital?

Debt to Equity Total Liabilities divided by Total Owner's Equity = Debt to Equity)

1. Is the debt to equity ratio greater or less than 1*? 2. If greater than one, are you comfortable with the amount of debt you have? Or do you feel it is risky? A ratio of 5, or 5:1 is considered risky. 3. If less than one, do you have too much of the own equity in the business. A ratio of .40 or 2:5 is considered hardly leveraged by debt. 4. What have banks told you about the level of debt or equity? 5. What recommendations have they made to you? 6. What changes do you want to make with respect to the debt? 7. What changes do you want to make with respect to the equity?

* Note: Service industry businesses often do not follow rule of thumb measures like 1:1 ratios. Small businesses especially are prone to lots of high profitability, no assets with lots of debt. This may make the ratio look 'bad' when in fact it can be just fine.

Long-term Liabilities (All accounts payable due beyond one year.)

Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707 Working On IT Tuesdays© Payoff Tools A Methodical Set of Questions 1 Is the client comfortable with the amount of debt he/she is carrying? 3. Are the long-term debts increasing or decreasing? 4. What are the contributing factors? 5. What is the current portion of the long-term debt? 6. Do you desire to accelerate the debt repayment? 7. What percentages are principle and interest? 8. Could you double or triple the principle amount without impacting operations too significantly? 9. Is it part of the Primary Aim/Personal Objectives and Strategic Objective to become debt free? 10. Or, is it desirable for you to always use some debt for investment in the growth of the business? 11. What changes do you want to make with respect to long-term liabilities?

Return on Revenues (Net Profit divided by Net Revenues = Return on Revenues)

1. This is the bottom line. Is it staying the same, increasing or decreasing? 2. What are the contributing factors? 3. Do you know what is average in the industry? 4. If not, do you know the SIC code (if in US) and can you get access to a Dunn and Bradstreet or Robert Morris & Associates guide in order to discover those averages? 5. What return on revenues (or net profit percentage) would you like to achieve? 6. What changes can you make short and long-term to improve the return on revenues?.

Return on Assets and Return on Equity

If this number is very low (less than 10%) the company is not making the most effective use of its assets. An important question to ask the client is, "why would you invest so much time and effort, and put yourself at so much risk, to earn such a low return on your investment?"

Days Sales Outstanding

This indicates how long it's taking the business to collect Accounts Receivable. For most businesses, this should be in the range of 20 to 30 days. If you are working with any type of construction business, 45 to 60 days is normal. Anything greater than these figures indicates that the business needs to pay more attention to collections.

Inventory Turnover (days)

This varies widely from industry to industry, so compare it to industry standards. Too much inventory (usually, anything over 20 to 30 days worth) can tie up a substantial amount of cash. Ask the client how he/she might reduce that inventory and free up some of that cash.

Automotive Service Leaders – The Turnaroundtour Company www.turnaroundtour.com Phone - 800-233-8551 Fax - 270-782-1707