“If I’m Making All This Money… How Come I’m Broke?!”

1. “If I’m Making All This Money…How Come I’m Broke?!” Presentation by Ralph Dazet, CPA

2. “If I’m Making all this Money … How Come I’m Broke?” Introduction ► Informal ► Ask questions

3. In the 50 years I have been practicing accounting, this question has frequently been asked by my clients… This session is designed to help answer that question!

4. What Will our Methodology Be? ► As usual, we will use a case study – the good ole – “Tie ‘Em Down Good Company”! (A metals distribution company servicing the marine and aerospace industries.)

5. 3,136,000 2,750,000 2,636,000 23% 24% 26% 2,454,000 2,177,000 2,028,000 20% 19% 18% 573,000 608,000 682,000 5% 5% 6% 237,000 223,000 267,000 350,000 371,000 415,000 3% 4% 3% Tie ‘Em Down Good, Inc. Financial Highlights Three Years Ended December 31, 2011 Year Ended OPERATIONS 12/31/11 12/31/10 12/31/09 Revenue 13,636,000 11,458,000 10,140,000 Gross Profit % of Revenue Operating Expenses % of Revenue Pre-Tax Income % of Revenue Income Tax Net Income % of Revenue

6. Year Ended FINANCIAL CONDITION 12/31/11 12/31/10 12/31/09 Working Capital 1,041,000 751,000 575,000 Ratio 1.3 to 1 1.3 to 1 1.2 to 1 Accounts Receivable 1,857,000 1,432,000 1,155,000 Days of Sales 49 days 45 days 41 days Inventory 3,000,000 2,124,000 1,745,000 Inventory Turns 3.5 turns 4.1 turns 4.3 turns Fixed Assets, Net 810,000 704,000 600,000 Accounts Payable 1,402,000 1,064,000 917,000 Days of Purchases 48 days 44 days 44 days Line of Credit 2,270,000 1,619,000 1,220,000 Collateral Coverage 1.25 1.30 1.40 Shareholders’ Equity 1,480,000 1,065,000 715,000

7. ► The financial statements we last examined – 12/31/11 disclosed: • Strong sales growth; • Strong profits; and • Tight cash flow and a slightly nervous bank

8. What Happens in 2012? ► Part of the dream comes through: • Sales shoot up by 20%. • Gross profit margin holds at 2011 margin! • Variable operating expenses are in line with sales growth! • Receivables, inventory and payables are in line with sales growth! • The company feels they have really managed the growth!

9. ► The Stage! The company, in an informal discussion with the banker, assures the banker that things are really looking good in 2012. • Sales are outstanding! • Profits are looking great! • I’m sure we can knock the debt down by the end of 2012!

10. ► What will the 2012 financials look like? The Income Statement Let’s examine the Summary of Assumptions used

11. Tie ‘Em Down Good, Inc. Summary Assumptions Year ending December 31, 2012 OPERATIONS • SALES • 20% growth from 2011 • GROSS PROFIT • Maintain 23% gross margin Expense • DEPRECIATION EXPENSE • Beginning of year – fixed assets - gross $ 910,000 Method & life – S.L 10 yrs. $ 91,000 $ 100,000 CURRENT YEAR ADDITIONS Method & life – S.L 10 yr, mid yr convention $ 5,000 TOTAL $ 96,000

12. EXPENSE IV. LEGAL EXPENSE Same retainer as 2011 $ 12,000 V. RENT EXPENSE Same operating leases and rate as 2011 $ 120,000 VI. TELEPHONE & UTILITIES 5% increase over 2011 Telephone $ 35,000 Utilities $ 38,000 VII. INTEREST Working capital loan Beginning of year $2,270,000 $ 182,000 Rate 8% LONG TERM DEBT Beginning of year Less ½ payments $ 445,000 Average balance (37,000) $ 408,000 Rate 9% 36,000 VIII. OTHER EXPENSE All other variable expenses increase at same rate as sales – 20% $ 218,000 IX. INCOME TAX Calculated at historical effective rate of 39.15% $ 343,000

13. Based on those Assumptions, let’s examine the Income Statement!

14. Tie ‘Em Down Good, Inc. Statement of Income Year ending December 31, 2012 Sales $16,363,000 Cost of goods sold 12,600,000 Gross profit 3,763,000 % of sales 23% Operating Expenses Accounting 35,000 Advertising 16,000 Bad debts 66,000 Delivery expense 32,000 Depreciation 96,000 Insurance – Group 101,000 Insurance – Casualty 144,000 Legal 12,000 Maintenance 40,000 Meals & entertainment 56,000 Miscellaneous 44,000 Office expense 30,000 Payroll tax 133,000 Rent 120,000 Telephone 35,000 Utilities 38,000 Wages – officers 492,000 Wages – office 274,000 Wages – sales 491,000 Wages – warehouse & delivery 414,000 Total 2,699,000

15. Operating income $1,094,000 Interest expense 218,000 Pre-tax income 876,000 Income tax 343,000 Net income $ 533,000

16. Wow! The sales growth and the Company’s management of gross profit margin and operating expenses has produced a bottom line growth from $415,000 in 2011 to $533,000 in 2012. A growth rate of 28%!

17. The Balance Sheet Let’s examine the Summary of Assumptionsused.

18. Tie ‘Em Down Good, Inc. Summary Assumptions Year ending December 31, 2012 • FINANCIAL CONDITION • Cash • Hold balance @ $ 50,000 • Accounts Receivable • Hold @ 49 days • Sales per day • Sales $16,363,000 • ÷ 360 days = $45,450 • x 49 days $ 45,450 $2,227,000 • Inventory • Hold @ 3.5 turns • Cost of goods sold $12,600,000 • ÷ 3.5 turns $3,600,000 • Prepaids • Hold @ $ 50,000 • Fixed Assets • Beginning balance, net @ 12/31/11 $ 810,000 • Plus current year additions 100,000 • Less current year depreciation (96,000) • Net balance @ 12/31/12 $ 814,000

19. VI. Working Capital Loan Hold @ $2,270,000 VII. Accounts Payable Hold @ 48 days Payables per day Cost of goods sold $12,600,000 ÷ 360 days 35,000 x 48 days $1,680,000 VIII. Accrued Expenses Hold @ $ 170,000 IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) Balance @ end of year $ 371,000 Current $ 74,000 Long-Term $ 297,000 X. Shareholders’ Equity Balance – Start of year $1,480,000 Current year profit 533,000 Balance @ at end of year $2,013,000

20. ► Based on those Assumptions, let’s examine the Balance Sheet (has the $533,000 bottom line profit earned, enabled the Company to reduce debt as promised?) ► If all of the Balance Sheet Assumptions come to pass and the Company generates a $533,000 bottom line, what will the resultant net increase or decrease in cash be?

21. Tie ‘Em Down Good, Inc. Balance Sheet Year Ended December 31, 2012 ASSETS Current Assets $ 50,000 Cash Cash, increase (decrease) Accounts receivable 2,227,000 Inventory 3,600,000 Prepaid expenses 50,000 5,690,000 Total current assets Fixed assets, net 814,000 Total Assets $6,504,000

22. $2,270,000 1,680,000 170,000 74,000 4,194,000 297,000 100,000 1,913,000 2,013,000 $6,504,000 LIABILITIES AND EQUITY Current Liabilities Working capital loan Accounts payable Accrued expenses Current portion long-term debt Total current liabilities Long term debt Shareholders’ equity Common stock Retained earnings Total shareholders’ equity Total Liabilities & Equity

23. -Answer- Cash goes down by ($237,000)

24. Why? With a substantial growth in sales (example 20%), the profits generated will not be able to self-finance the resultant growth in Receivables and Inventory – even if management is able to hold this Inventory and Receivable growth in line with sales!

25. What happens if management, in its great rush to grow the business, allows gross profit margins to slip a little and receivable and inventory management to slip a little (look at history) ► We call this “the Norm”! ► Looking back over the Company’s recent history, suppose the rapid sales growth produces the following effect on operations and financial conditions. Operating Assumptions

26. Tie ‘Em Down Good, Inc. Summary Assumptions Year ending December 31, 2012 OPERATIONS All Assumptions are the same as in the first illustration, except for projected gross profit %. This illustration assumes that the rapid growth in sales (20%) will result in a 1% slippage in gross profit from 23% to 22%.

27. Balance Sheet Assumptions

28. Tie ‘Em Down Good, Inc. Summary Assumptions Year ending December 31, 2012 • FINANCIAL CONDITION • Cash • Hold balance @ $ 50,000 • Accounts Receivable • Slip from 49 days to 52 days • Sales per day • Sales $16,363,000 • ÷ 360 days = $45,450 $ 45,450 • x 52 days $2,363,400 • Inventory • Slip from 3.5 turns to 3.2 turns • Cost of goods sold $12,763,100 • ÷ 3.2 turns $3,989,000 • Prepaids • Hold @ $ 50,000 • Fixed Assets • Beginning balance, net @ 12/31/11 $ 810,000 • Plus current year additions 100,000 • Less current year depreciation (96,000) • Net balance @ 12/31/12 $ 814,000

29. VI. Working Capital Loan Hold @ $2,270,000 VII. Accounts Payable Hold @ 48 days Payables per day Cost of goods sold $12,763,100 ÷ 360 days 35,500 x 48 days $1,704,000 VIII. Accrued Expenses Hold @ $ 170,000 IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) New balance @ end of year $ 371,000 Current $ 74,000 Long-Term $ 297,000 X. Shareholders’ Equity Balance – Start of year $1,480,000 Current year profit 434,000 Balance @ at end of year $1,914,000

30. ► If the Assumptions all come to pass, what will the financial statements look like? • The Income Statement

31. Tie ‘Em Down Good, Inc. Statement of Income Year ending December 31, 2012 Sales $16,363,000 Cost of goods sold 12,763,000 Gross profit 3,600,000 % of sales 22% Operating Expenses Accounting 35,000 Advertising 16,000 Bad debts 66,000 Delivery expense 32,000 Depreciation 96,000 Insurance – Group 101,000 Insurance – Casualty 144,000 Legal 12,000 Maintenance 40,000 Meals & entertainment 56,000 Miscellaneous 44,000 Office expense 30,000 Payroll tax 133,000 Rent 120,000 Telephone 35,000 Utilities 38,000 Wages – officers 492,000 Wages – office 274,000 Wages – sales 491,000 Wages – warehouse & delivery 414,000 Total 2,699,000

32. Operating income $ 931,000 Interest expense 218,000 Pre-tax income 713,000 Income tax 279,000 Net income $ 434,000

33. The (1%) drop in gross profit margin reduced net income from $533,000 to $434,000 (which is still ahead of prior year results of $415,000)!

34. Balance Sheet

35. Tie ‘Em Down Good, Inc. Balance Sheet Year Ended December 31, 2012 ASSETS Current Assets $ 50,000 Cash Cash, increase (decrease) Accounts receivable 2,363,000 Inventory 3,989,000 Prepaid expenses 50,000 5,615,000 Total current assets Fixed assets, net 814,000 Total Assets $6,429,000

36. $2,270,000 1,704,000 170,000 74,000 4,218,000 297,000 100,000 1,814,000 1,914,000 $6,429,000 LIABILITIES AND EQUITY Current Liabilities Working capital loan Accounts payable Accrued expenses Current portion long-term debt Total current liabilities Long term debt Shareholders’ equity Common stock Retained earnings Total shareholders’ equity Total Liabilities & Equity

37. Based on those Assumptions, let’s examine the Balance Sheet. • What has this $434,000 bottom line from operations produced?

38. -Answer- • Cash goes down by $837,000 … • OUCH!!! • If our historical trends continue, the Company may NOT be able to finance this growth. • Yes, Virginia… • "You can sell yourself out of business!"

39. How do we solve this problem? • ► Slow down sales? • Is this an acceptable answer for almost all companies? • ► Monitor and target acceptable levels of “Days of Sales” and “Inventory Turns” • Assign responsible people to monitor and have definite reporting schedules with a set meeting schedule (no less than once a month). • Further slippage is NOT acceptable – the Company cannot reasonably expect to finance a $837,000 negative cash flow!

40. ► At the start of the year, the Company must prepare, very carefully, a realistic Operatingand Cash Flow Budget. • All effected parties: • a. Ownership; • b. Sales department; • c. Inventory department; and • d. Accounting department • must provide input and acceptance!

41. ► After this operating and cash flow budget is prepared, management must meet with its commercial lender and determine the lender’s approval of the Company’s plan and obtain from the lender a commitment of their participation. • ► If management anticipates continued future growth of this magnitude, the Company should begin to explore additional sources of capital. • Expanded investment from existing stockholders. • Possibility of investment by individuals who are willing to be minority shareholders. • Venture capital groups.

42. Let’s not lose sight of the best solution! ► Management learns to manage the Balance Sheet as well as it manages the Income Statement! ► What would happen if instead of “holding our own”, the Company actually improved its management of:

43. Tie ‘Em Down Good, Inc. Summary Assumptions Year ending December 31, 2012 • FINANCIAL CONDITION • Cash • Hold balance @ $ 50,000 • Accounts Receivable • Improve to 45 days • Sales per day • Sales $16,363,000 • ÷ 360 days = $45,450 $ 45,450 • x 45 days $2,045,400 • Inventory • Improve to 4.1 turns • Cost of goods sold $12,600,000 • ÷ 4.1 turns $3,073,000 • Prepaids • Hold @ $ 50,000 • Fixed Assets • Beginning balance, net @ 12/31/11 $ 810,000 • Plus current year additions 100,000 • Less current year depreciation (96,000) • Net balance @ 12/31/12 $ 814,000

44. VI. Working Capital Loan Hold @ $2,270,000 VII. Accounts Payable Hold @ 48 days Payables per day Cost of goods sold $12,600,000 ÷ 360 days 35,000 x 48 days $1,680,000 VIII. Accrued Expenses Hold @ $ 170,000 IX. Long Term Debt Beginning balance @ 12/31/11 $ 445,000 Less payments (74,000) Balance @ end of year $ 371,000 Current $ 74,000 Long-Term $ 297,000 X. Shareholders’ Equity Balance – Start of year $1,380,000 Current year profit 533,000 Balance @ at end of year $1,913,000

45. “Days of Sales” from 49 days to 45 days “Inventory turns” from 3.5 turns to 4.1 turns What would the Balance Sheet look like then? (Remember when the Company “held its own”, with a 20% growth, the $533,000 net income turns into a $(237,000) negative cash flow.

46. Tie ‘Em Down Good, Inc. Balance Sheet Year Ended December 31, 2012 ASSETS Current Assets $ 50,000 Cash Cash, increase (decrease) 472,000 Accounts receivable 2,045,000 Inventory 3,073,000 50,000 Prepaid expenses 5,690,000 Total current assets Fixed assets, net 814,000 Total Assets $6,504,000

47. $2,270,000 1,680,000 170,000 74,000 4,194,000 297,000 100,000 1,913,000 2,013,000 $6,504,000 LIABILITIES AND EQUITY Current Liabilities Working capital loan Accounts payable Accrued expenses Current portion long-term debt Total current liabilities Long term debt Shareholders’ equity Common stock Retained earnings Total shareholders’ equity Total Liabilities & Equity

48. ► As disclosed in the following illustration, the net effect of the improvement in receivable “Days of Sales” and “Inventory Turns” would convert to a negative cash flow of $(237,000) to a positive cash flow of $472,000. • ► Is this possible? • The 45 Days of Sales in the illustration merely returns to 2010 results. • The 4.1 Inventory Turns in the illustration merely returns to the 2010 results. • It should be noted that these results are in the mid-range of performance for the metals distribution companies in the Robert Morris survey and the Metals Distributors Trade survey published results.

49. How Can We Best Monitor and Improve Performance in this Cash Flow Area? • ► Review past history and use this understanding to predict future results. • ► Improve our ability in projecting cash flow. • ► Develop acceptable “benchmarks” of performance. • Assign responsible management personnel to monitor and report on these results with a formal meeting schedule. • Develop a reward system for acceptable performance.

50. ► Develop a program to meet with the Company’s commercial lender in advance, and • Lay out the Company’s expected operating results and projected cash flow results. • Obtain a commitment from the lender that they are willing to meet our commercial lending needs for the following year.