I Made a Profit—But Where’d the Cash Go?

[Pages:4]I Made a Profit--But Where'd the Cash Go?

When a shop owner's income statement shows that the business made a profit but the checkbook balance tells a different story,

the first question he asks is, `Where'd the money go?'

BY BOB O'CONNOR

800-755-0988

Our experience indicates that most shop owners have very little accounting acumen and, therefore, only a cursory understanding of the elements of a financial statement. Many measure profitability by their checkbook balance after all bills are paid. This is a dangerous practice, since a checkbook does not reflect accrued items such as accounts payable, operating expenses, payroll, taxes, etc.

To demonstrate how the cash can "disappear" in a shop, let's look at a case scenario that we've used many times to illustrate various financial points.

Case Scenario

Joe Wrench worked in repair shops as a technician for over 12 years, but felt he could earn more money and achieve greater personal satisfaction if he went into business for himself. So he opened Illustrative Auto Repair.

The new business attracted many customers based on Joe's strengths--he was

an excellent technician, and he had the ability to deliver quality repairs at reasonable prices. As customer load increased, Joe hired additional technicians, and now employs three.

Joe tried to make his shop even more profitable by purchasing used cars in need of repair, fixing them in his shop during "slow" times, then reselling them to his customers. Shortly after opening, Joe's wife Terri joined him in the business, performing tasks such as answering the phones, picking up parts, shuttling customers and keeping the company books. Terri had no formal training in accounting, but felt that she had a good understanding of bookkeeping as a result of managing their home finances.

It's now the middle of Joe and Terri's second year in business. The shop is very busy, and they're working long hours. But they both feel that they aren't getting ahead-- the P&L statement they receive from their accountant each month indicates that they're making a profit, but for some reason are not accumulating any cash.

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Let's review the financial statement of Note that this shortened version of the that prior to the start of a new year, a

Joe and Terri's repair shop and see if we Income Statement for Illustrative Auto method of handling bad debts is elect-

can determine where the cash is going. Repair shows net income for the first six ed. In this instance, the allowance for

Methods of Accounting

months of 2001 to be $5711.90 after bad debts is calculated using prior bad taxes. These earnings are meager--only debt experience and takes into ac-

There are basically two recognized slightly over 3% of sales; however, they count customer receivables that are

methods of accounting--accrual and do represent a profit instead of a loss. over 90 days old. The current provi-

cash. Most accountants prefer and rec- Balance Sheet. The second element sion is 1% of the accounts receivable

ommend the full accrual method in ac- of a financial statement is the Balance at the reporting date.

cordance with generally accepted ac- Sheet. Most repair shops produce or The next section of the Balance

counting principles. But most auto re- obtain a Balance Sheet also on a month- Sheet covers property and equipment,

pair shops don't have the expertise on ly basis, just like the Income Statement. which is often referred to as fixed assets

staff to implement

and includes items

full accrual account-

such as furniture, fix-

ing, and most can't afford to pay an outside firm to provide

Statement of Income June 30, 2001

tures and equipment. Adding total current assets and property

the service. There-

and equipment (after

fore, more often than

YTD

%

depreciation), results

not, most use some accrual methods and

Total Sales............................. $180,984.63 .......... 100.00

in a total assets figure of $45,580.21.

some cash methods,

The third section

which results in a rel- Cost of Sales........................... 105,080.59 ............ 58.06 of the Balance Sheet

atively accurate fi-

lists current liabili-

nancial statement. Gross Profit............................... 75,904.04 ............ 41.94 ties--items that must

However, the prac-

be paid out when

tice of combining the two often leaves some holes that can create significant problems.

Financial state-

Operating Expenses Bad Debt Expense ................................. 65.45 .................. .04 Depreciation ..................................... 2,815.20 ................ 1.56 Interest.............................................. 1,938.60 ................ 1.07 Other Operating Expenses............. 63,872.86 .............. 35.28

sufficient cash is available. In this instance, the total is $31,503.01, and Illustrative Auto Repair doesn't have enough

ments consist of three major compo-

Total Operating Expenses ....... 68,692.14 ............ 37.95

cash in the bank, even if it collected all

nents--a Statement of Income, a Balance Sheet and a State-

Operating Income (Before Income Tax) ................. 7,211.90 .............. 3.98

of its accounts receivables. So information that would help de-

ment of Cash Flows. We'll explain what

Income Taxes .............................. 1,500.00 ................ .83

termine where the cash is going could

they are and why

be very valuable to

they're important, then see how they re-

Net Income......................... $5,711.90 ............ 3.16

Joe and Terri, as it would enable them

late to Illustrative Au-

to make good busi-

to Repair's situation.

ness decisions.

Income Statement. The first ele- Referring to Illustrative Auto Repair's The next section shows long-term lia-

ment of a financial statement is the In- Balance Sheet (shown on page 59), note bilities totaling $2449.52, after making

come Statement. Illustrative Auto Re- that the first section shows its current the adjustment for the current portion

pair's Income Statement (shown above) assets, which encompasses cash in the of long-term debt.

reflects the shop's total sales, cost of bank, accounts receivable and invento- The last section reflects Stockholders'

sales, expenses and, finally, the total ry, and makes allowance for bad debts. Equity of $11,627.68, which is deter-

earnings for the first six months of 2001. The shop's total current assets comes to mined by subtracting current and long-

Most repair shops produce or obtain an $24,639.17.

term liabilities from total assets.

Income Statement on a monthly basis. "Allowance for bad debts" means Statement of Cash Flows. More

54

December 2001

than 95% of the financial statements we review for new clients every year do not include a Statement of Cash Flows, the third element of a financial statement. When we ask why, most clients say they've never seen one or their accountants have never offered to provide them with one. The absence of this document, along with the explanation of why it's important, is the reason that most shop owners don't understand why they have less money in the bank than their Income Statement indicates they earned.

The compilation of the Statement of Cash Flows requires obtaining figures from both the Income Statement and Balance Sheet. The first section reflected on Illustrative Auto Repair's Statement of Cash Flows (shown on page 60) is cash flows from operating activities. The first entry--net income--is taken directly from the Income Statement. The next two entries--depreciation ($2815.20) and provision for bad debts ($65.45)--are considered additions to cash, since they represent "book" adjustments and do not actually represent cash expenditures. They're taken from the operating expenses area of the Income Statement.

The next section of the Statement of Cash Flows reflects the net changes in assets and liabilities. The first entry in this area indicates that accounts receivable monies ($11,886.99) were collected and therefore added to cash. The second entry in this area indicates an increase in inventory of $3683.83, which would then be subtracted from cash. In this instance, the collection of accounts receivables was meaningful because it added cash to the bank account. Unfortunately, putting out cash to increase the inventory with the business short on cash may not have been a good business decision.

The third entry in this area indicates that accounts payables were reduced by $10,720.32, which also is subtracted from cash. The last two entries in this area reflect a reduction in

Balance Sheet--June 30, 2001

Current Assets

Cash in Bank - General Account ...... $8,000.07 Accounts Receivable .......................... 6,544.55 Allowance for Bad Debts ...................... (65.45) Inventory .......................................... 10,160.00 Total Current Assets .............................................. 24,639.17

Property & Equipment (Fixed Assets)

Leasehold Improvements ................ 15,741.00 Furniture & Fixtures.......................... 20,246.00 Machinery & Equipment .................... 8,494.52 Accumulated Depreciation ............ (23,540.48) Total Property & Equipment

Assets (after Depreciation) .............................. 20,941.04

Total Assets ............................................ 45,580.21

Current Liabilities

Accounts Payable................................ 5,051.49 Accrued Payroll Taxes ........................ 4,066.34 Accrued Business Taxes ...................... 1,836.88 Federal Income Tax Payable .............. 1,384.00 Notes Payable .................................. 13,000.00 Current Portion of Long-Term Debt .... 6,164.30 Total Current Liabilities ........................................ 31,503.01

Long-Term Liabilities

Contract Payable ................................ 8,613.82 Less: Current Portion ........................ (6,164.30) Total Long-Term Liabilities...................................... 2,449.52

Stockholders' Equity

Common Stock, 1,000 Shares Authorized, Without Par Value; Issued and Outstanding 100 Shares at Stated Value of $24 Per Share....................2,400.00

Retained Earnings .............................. 9,277.68 Total Stockholders' Equity .................................... 11,627.68

Total Liabilities & Stockholders' Equity ........................ $45,580.21

December 2001

59

payroll taxes and a reduction of business taxes, both also deducted from cash. The effect of the additions and subtractions of cash in this area equals a net reduction in cash of $1635, leaving a balance of $4076.90 net cash from operating activities.

The next two sections of the Statement of Cash Flows--cash flows from investing activities and cash flows from financing activities--show reductions in cash for principal payments made on property and equipment ($870.24) and principal payments made on notes payable ($2843.28). Interest on those

payments is reflected in the operating expenses section of the Income Statement. Adding these two figures together and subtracting the total from the balance of $4076.90 (net cash from operating activities) leaves a net increase in cash of only $363.38. That's a significantly different figure than the $5711.90 shown as net profit on the Income Statement!

What Are the Options?

After reviewing the Statement of Cash Flows, Joe and Terri have a number of options open to them to help solve

Statement of Cash Flows for the Six Months Ended June 30, 2001

Increase and (Decrease) In Cash

Cash Flows From Operating Activities:

Net Income .................................................................. $5,711.90 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation - property & equipment ........................ 2,815.20 Provision for bad debts...................................................... 65.45 Net change in assets & liabilities: Decrease in accounts receivable ................................ 11,886.99 Increase in inventory .................................................. (3,683.83) Decrease in accounts payable .................................. (10,720.32) Decrease in accrued payroll taxes.................................. (524.08) Decrease in accrued business taxes ............................ (1,474.41) Total Adjustments ........................................................ (1,635.00) Net Cash Provided by Operating Activities ................ 4,076.90

Cash Flows From Investing Activities:

Payments for property & equipment ............................ (870.24)

Cash Flows From Financing Activities:

Principle reduction, notes payable ............................ (2,843.28)

Net Cash Used in Investing & Financing Activities........................ (3,713.52)

Net Increase In Cash .................................. 363.38 Cash at Beginning of Year .................... 7,636.69 Cash at End of Current Period ............ $8,000.07

their cash problems. First, they could investigate restructuring their debt by extending the term, thereby reducing the payments. They may even be able to borrow on their assets to both acquire cash and extend the term of their debt. Collecting on the balance of accounts receivables and not extending additional accounts receivables would also put cash in their bank account. Finally, they could evaluate their inventory needs and, if feasible, reduce the inventory, taking credits toward future purchases for resale.

This business obviously needs other work. However, if all or some of these options were made part of an overall action plan to turn this business around, they would lead to both an influx of cash and cash conservation.

If you're a shop owner experiencing a shortage of cash, we recommend that you have your methods of bookkeeping and accounting reviewed, with an eye to moving toward full accrual accounting. Also, if you don't have one, immediately create or have done a Statement of Cash Flows. Hopefully, once you've implemented these two recommendations, you'll never again have to ask yourself, Where'd the cash go?

Robert "Bob" O'Connor is President of R.L. O'Connor & Associates, Inc., a Seattle-based automotive operations and management training and consulting firm. He is best known in the U.S. and Canada for his automotive management training workshops and his continuous improvement BottomLine Impact Groups. Bob is an Automotive Management Institute (AMi) approved instructor and AMi EXCEL 2000 "Guarantor."

Visit to download a free copy of this article. Copies are also available by sending $3 for each copy to: Fulfillment Dept., MOTOR Magazine, 5600 Crooks Rd., Troy, MI 48098.

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December 2001

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