A CEO’S NIGHTMARE

BY: PAT POWERS, CPA

AUGUST 9, 2017

In the mid ‘90s I became a Regional President for a workers’ compensation company although I had no previous experience in the industry. My value to this company was my recent experience in the managed care industry. I had regional responsibility for functions such as sales, regional legal issues, underwriting, and claims but not for information technology, human resources, actuarial services and finance.

During my first 2 ? years, my region was the darling of the company. Our performance was held up as an example for other regions. During the summer of my 3rd year I got a call from the finance director at the home office who was responsible for my region’s financial statements. He informed me that an error had been discovered in the software that calculated the reserves on open claims and that an adjustment was going to be recorded on the current month’s financial statements. “How much” I asked. With some hesitation, he told me that it would wipe out the region’s net income for the past 3? years. Since my region constituted a significant portion of the company’s bottom line, the effect on the company’s net income was going to be substantial. I was held accountable for this accounting error by the CEO and was terminated a few months later.

Once again, I learned the value of 20-20 hindsight. I may have been able to identify this problem, which began about a year prior to my employment, if only (how many times have each of us began a sentence about a life changing event with “If only.”) I had performed some basic ratio analysis and compared the results to industry standards. If this article prevents what happened to me from happening to one other person, then I will consider the time I spent writing it to be time well spent.

If you are a candidate for a position or currently in a position where you will have responsibility for net income, this article is for you. If your company or not-for-profit organization does not have an outside financial professional analyzing the financial statements on a regular basis, please read on.

Financial ratios, trend analyses, industry comparisons and other tools are ways to evaluate and interpret a company’s financial statements and its financial viability and your future employment. There is a myriad of sources available on the internet that can help the novice or the expert understand how to calculate and use the ratios and develop the trend analyses discussed below.

So, you’re in a new position or being recruited for a position with profit and loss responsibility - what should you do? There is a number of tools that can help flag risks hidden in a company’s financial statements as well as identify potential financial issues. None of these tools are guaranteed to expose problems but they will help you raise questions that need answers. If that previous sentence sounds like a disclaimer, that’s because it is. It’s tough but not impossible to find issues with financial statements when two or more individuals in the right place conspire to “cook the books” or to commit fraud. Also, in many cases, the actions taken by a finance person that can affect the image of a company painted by the financial statements are a matter of opinion. An example is the life assigned to depreciable assets. Sometimes the standard for the life assigned is a range. Depreciation can be controlled depending upon the length of the life chosen. The philosophy of the company’s executives and board will usually impact this decision.

In most any business, cash is king. With enough available cash, companies can navigate their way through most any adversity. Here are a few steps that can be taken to determine the accuracy and sufficiency of cash.

? Compare the ending balance on the bank statement to the bank balance shown on the checking account reconciliation. If these aren’t the same, you’ve found the first problem.

? Verify the existence of cash equivalents (CDs, money-market accounts, savings, etc.) by calling the bank or financial institution where these are held.

? Calculate the company’s quick ratio and current ratio over a period of time and analyze their relationships

? If these are inching up over time, that’s a good sign

? Compare these to industry standards

Meet by yourself with the company’s bank officer to get his/her feedback on the company. Find out or ask for:

? Loan and line of credit statements showing the current balance

? If the company is in compliance with any loan or line of credit covenants

? Get the bank officer’s opinion of the financial operation of the company

? Ask for any concerns the officer has about the company’s future

Sales and accounts receivable are other basic areas which should be examined. Sales going up or down over time should have a similar effect on accounts receivable. If not, ask why. If sales are constant but receivables are trending down, it could be the company has gotten aggressive on collections due to a need for cash. If the opposite is true, there will be pressure put on cash to meet current obligations. Remember, you can’t write a check on your receivables. You should review the aging of accounts receivable and compare the information for different time periods as well as to industry standards.

Review the relationship between accounts payable and operating expenses over several periods. Similar to the relationship between sales and accounts receivable, analyzing accounts payable and operating expenses can also point out issues with both cash and the direction in which a company is headed. Ask for an aging of accounts payable and go through the same analysis as outlined above for accounts receivable.

A critical indicator to review is gross margin ratio. This is the company’s gross profit (net sales less cost of goods/services sold) divided by net sales. Compare the movement of this ratio over time – going up is great; going down is not so good. Also, how does it compare to industry standards? If the relationship to the industry does not seem reasonable, get an explanation as to why.

Look at budgets and financial projections. Find out how the company performed for the previous fiscal year compared to budget. Ask what the plans are to correct any substantial negative variances. Discuss the underlying assumptions for the current year’s revenues, expenses and cash flow. Insure that balance sheet information used in budgets and other financial projections are based on the ending balance sheet for the period immediately preceding the first period used in the projections being reviewed.

There’s two old adages that I use a lot when discussing financial statements and business plans:

? “If it’s too good to be true, it probably is.” It usually only in fairy tales and fiction where good things happen that exceed our wildest imagination.

? “Pigs get fat; hogs get slaughtered.” Unless a company gets lucky like Mark Zuckerman or Bill Gates and comes up with a revolutionary idea and then actually makes it happen, steady growth year after year is how most companies achieve long term success.

Common sense and skepticism along with the use of the tools reviewed above will help you avoid the mistake I made.

(Pat Powers, CPA is the owner of Powers Consulting Company. His company has the experience and resources to help companies develop solid financial, marketing and customer services plans and operations.)