Are you a new investor, board member, or CEO of a company? Are you 100% confident that the accounting policies are valid and transparent, that no-one has taken some accounting liberties in the past that still lurk in the shadows, that the operating profit reporting you're receiving is correct? Given all the transgressions displayed by public companies in the past, it would be hard to be so confident, even with the Sarbanes Oxley bureaucracy loaded in. And, if its a private company; double beware. I was called into a situation several years ago when a very smart private equity firm got completely fooled by misleading accounting policies by a company I'll call Acme, leading to a bankruptcy six months after their major investment. More on that later!
Accrual accounting (vs. cash accounting) serves a great purpose; basically matching revenues with costs. But it provides many, many opportunities for unscrupulous or simply wishful accounting decisions that can lead to misleading operating profits reporting. When I come into a new company, I could do a search and destroy on every accounting policy but that takes resources and there are always other things to do. So instead I put in place a relatively simple adjusted cash accounting system, the Liquid Balance Sheet, to validate my company's accrual accounting reporting. You can, and should, too. This is rather technical but really easy. Here's how it works.
Just tell your CFO to fill out the following form every week, simply taking the data directly off the general ledger with no accrual adjustments, closing entries, or other adjustments, a process taking about 30 minutes max. It's basically taking the unadjusted current assets, subtracting the unadjusted current liabilities, and adjusting for non-operational financial transactions. The column headings are:
Week #
Cash - A/R - Inv. - Other - Current Assets total
A/P - Other - Current Liab.
Fin. trans. - Weekly Chg. - Cumulative Chg.
Obviously Cash + A/R + Inventories + Other assets ='s Current assets, and A/P + Other liabilities ='s Current Liabilities. The only heading requiring explanation is "Fin. trans.", which means any flow in or out of the company not related to operations, such as borrowing against a credit line, repaying a loan, or getting an equity infusion. These cash items do not relate to operations so you need an adjustment.
Then interpreting the results is relatively simple. If the Cumulative Change column over the course of several weeks or months is roughly consistent with your feel for the financial performance of the business and with the reported operating profits, then you can be at ease. This Cumulative Change column accurately measures the weekly flow of those items that measure your performance on a "cash accounting" basis. If the Cum. Chg. column over the course of several weeks or months is way out of line with the reported operating profits, sound the alarms. After the fact I put this process in place with Acme and found that, had it been done at the time, the investor firm would've easily uncovered this problem at least three months earlier when there still might have been time for correction. The company had reported operating profits during the period, but the cash accounting balances were spiraling downward.
Cash accounting is too simple for today's environment. But as a parallel check on the many, and many times mystifying, accrual accounting policies it can be invaluable.
Too often owners, investors, directors and even CEO’s don’t recognize unacceptable levels of cash consumption until it’s too late. A critical task is to know what the operating cash flow of the company is…not the cash on the balance sheet, not the cash flow calculated from earnings, not the cash flow after financing transactions, but the true operating cash flow. You can’t easily be fooled if you know that, and you can’t get into serious trouble if you manage it effectively.
Cash is so important it should not be calculated but rather tightly understood. Viewing cash somewhat abstractly is dangerous. In 2001, an LBO fund with a group of very smart guys made just such a mistake.
They invested $150M into a company I’ll call Acme. The organization was a consolidation of several consulting firms, including a hot consultant to the dot-com world. Acme was itself hot; it had an important presence in its hometown of Chicago and was racing forward via its public equity market hype and the recent acquisition.
180 days after the investment, the LBO group received troubling calls. I was asked to go along with their investigating team with the possibility of taking over as interim CEO. Here’s how the crisis looked at first glance:
• The $150M had already been consumed; the company was basically out of cash.
• Unpaid bills were being unloaded on the accounts payable dock by the truckload, and a good chunk of any additional investment would go out the back door as fast as it came in the front.
• Over a protracted period, the company had created a large category of unrecorded liabilities through various deals for instant accommodations in exchange for future work. Fulfilling this work would result in expense with no revenue: plain old cash out.
Wow! How did all that happen in 180 days without the LBO guys catching on? Well, accounting got in the way and gets in the way—even if properly applied, and even more so when improperly applied! Here’s why.
First, hardly anyone looks at cash accumulations in the monthly statements. The usual focus is to determine that revenues and bottom-line operating profits are in reasonable shape. On top of this, a major close of the books doesn’t happen until the end of a quarter.
Then the end of the quarter comes, the company closes, they go through a ton of adjustments, accruals, reserves, period costs and so forth before finally coming out with their idea of a bona fide quarterly operating and cash flow statement. It’s now 90 + 120 days later and the horse has been out of the barn so long it’s in the next state.
This all assumes the CEO and the CFO are either clueless or conniving…but if they weren’t one or the other, we wouldn’t be having this conversation in the first place. So Acme was hopeless and helpless and hapless, its cash liabilities had grown faster than anyone could count, and after considering all of this, the investor let it bite the dust—bankruptcy dust, that is.
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