Increasing on investment accounts are obviously symptoms that a controller [financial managers or even CFO] should react immediately. It indicates the presence of a multitude of potential illnesses on the company’s financial performance. Such symptoms are ones that a typical controller, armed with an adequate financial reporting system, can spot with a cursory review of the financial statements. In this post, I noted the investment accounts [i.e.; Accounts Receivable, Inventory and Fixed Asset] symptoms, and then describe the forms of financial analysis one should undertake in order to precisely determine the nature of the illness, followed by brief descriptions of possible solutions.
However, each level of analysis recommended in this post requires much more time to complete, so one should expect the most thorough analysis to require days or weeks of effort. When it looks as though the analysis work will be substantial, a controller should always consider two options:
- Option#1. Immediately stop further analysis work as soon as preliminary analysis results indicate that the underlying problem has probably been found, so that corrective action can be taken as soon as possible. After all, a highly detailed proof of the problem, accompanied by a tastefully packaged analysis and presentation, does not do much good if a terse e-mail summarizing preliminary results could have warned the management team a week sooner.
- Option#2. Construct new financial reporting systems that quickly and accurately collect and summarize much of the financial analysis work that was previously completed by hand, thereby saving large amounts of time. This second approach can be very expensive if a controller is determined to build reporting systems to spot every conceivable problem area.
A combination of both approaches allows a controller to rapidly determine problem areas and disseminate information to management about not only the problem, but also suggested solutions.
The Investment In Accounts Receivable Is Increasing
What to do? Here are what to do:
. Check the turnover trend. The first step is to see if the increase in accounts receivable is based on an increase in sales volume. For example, if a customer has purchased far more than the usual amount recently, the company will be funding the customer for the amount of this purchase until the contractually agreed-upon payment date has been reached. Consequently, to determine if the accounts receivable turnover rate has changed, run a trend line for this measure for at least the last quarter by dividing accounts receivable into the annualized sales for each month being measured.
Controller’s recommendation: Review sales to see if the increase in sales will continue. If so, arrange for more debt funding to cover the projected increase in accounts receivable.
. Check turnover trend by customer. If the accounts receivable turnover trend is worsening, the next step is to determine which customers are not paying on time. This can be done either by calculating the turnover trend for each customer or by skimming through the accounts receivable aging to see which customers have large overdue balances.
Controller’s recommendation: If a specific customer is not paying on time, then possible remedies range from a visit to the customer to discuss payment terms, to cutting off additional credit, reducing the preset credit limit, or even filing a lawsuit to collect funds.
. Check the credit granting process. If a customer is clearly unable to pay for goods received, an additional question is how did the customer ever receive credit terms sufficient to allow for significant bad debt to accumulate? This calls for a review of the credit granting process to ensure that credit checks are conducted and credit limits approved by authorized personnel.
Controller’s recommendation: Besides the corrective actions just noted, the management team should ensure that credit reviews for existing customers are done at regular intervals, to ensure that changes in the financial condition of customers are spotted in a timely manner and credit terms changed to match the new financial situation.
. Review for fraud. If there is some difficulty in contacting the customer, or if further review reveals that the customer no longer exists, there may be some chance of a fraudulent situation where the customer never had any intention of paying for the goods or services delivered.
Controller’s recommendation: Not only should there be a detailed review of the credit granting process to ensure that newly incorporated customers are especially carefully screened, but also that there is no linkage between employees granting credit and the customers who have fraudulently taken delivery of company goods or services.
The Investment In Inventory Is Increasing
What to do? Here are what to do:
. Check the turnover trend. If sales are increasing, then the amount of inventory needed to support those sales may be justified. To verify if this is the case, calculate a trend line for inventory turnover for at least the last quarter of a year. To do so, divide the current inventory balance into the annualized cost of goods sold. If the turnover proportion has dropped, then there is proportionally more inventory on hand than is justified by the increase in sales.
Controller’s recommendation: Review the cause of any increase in sales to see if the increase is projected to continue. If so, the increased inventory level is unlikely to decline, and additional funding will be necessary to support the added inventory investment.
. Review the last date on which inventory was used. If inventory turns have worsened, then one possible problem is that some of the inventory is obsolete. One way to check this is to review the dates when inventory was last used. One approach is to see if there is such a date tracked by the computer system, or if there are dated inventory tags on the inventory items or dated shipping labels on the inventory. Then, compile the dollar value of all items that have not been used in some time to determine the level of obsolescence.
Controller’s recommendation: Institute a periodic inventory liquidation procedure, so that all old inventory items are regularly reviewed and sold off.
. Verify where parts are used. Another way to determine inventory obsolescence is to see where parts are being used. The best way is to use the “where used” feature that is common in most manufacturing computer systems, allowing one to enter a part number and have the system feed back information about the products in which those parts are used. If there are no products in which they are used, the parts are clearly obsolete.
Controller’s recommendation: There must be a reason why parts are in stock, even though there are no products in which they are used. The usual reason is that the engineering staff has changed to a new part without first using up the old stock of parts. Accordingly, one action for management is to review the unused parts to see if they can still be used in the newer, revised products, and secondly, to set up a procedure so that the engineering staff is forced to use up existing inventories before switching to a new part.
. Review the sales trend for all finished goods kept in stock. If it is evident that the bulk of the inventory is in finished goods, one should verify the sales trends for all products for which there is some inventory. If sales trends are declining and the amount of on-hand inventories are high, there may be a problem liquidating the inventory.
Controller’s recommendation: Set up a procedure with the production scheduling staff to ensure that additional production is not scheduled for any item that is experiencing a drop in sales. Also, have the sales staff run a promotion or temporary price decrease to clear out all excess finished goods inventories for products that are experiencing slow sales volume.
. Review the turnover for work-in-process inventories. If there are no problems with either raw materials or finished goods inventories, we are left with work-in-process (WIP) inventory. See if the inventory turnover level for WIP has changed significantly over the last few months by creating a trend line for WIP inventory turnover (calculated by dividing the current WIP inventory total by the annualized cost of goods sold).
Controller’s recommendation: See if there are any partial assemblies that have not been completed for lack of parts or machine capacity, and finish them. Also, verify that there is not an excessive quantity of WIP kept in a quality hold area for repair work. Also, verify that WIP is not piling up in front of a bottleneck operation; if there is, either cut back on the production coming from upstream work centers, or increase the capacity of the bottleneck operation. Finally, see if WIP is being held up at off-site locations or suppliers for finishing work; if so, expedite all such completion activity.
. Verify the size of purchased quantities. It is possible that the purchasing department is trying to obtain low per-unit costs by purchasing in excessively large quantities. If so, there will be very large on-hand quantities of selected parts.
Controller’s recommendation: Have the purchasing staff review the cost of buying in smaller multiples, and buy in this manner if there is a reasonable cost-benefit tradeoff. If not, then buy in large multiples, but issue releases from the suppliers’ stock in weekly or smaller increments, so that the company is paying for only a portion of the total purchase at one time.
. Look for costing errors. If there is no evident change in the quantities of any inventories, it is possible that the per-unit cost has been accidentally changed in the inventory database. If so, compare the per unit cost of each item for the current period and for the same items in a previous period. If there are significant differences, review the reasons for the costing changes.
Controller’s recommendation. Lock down the inventory costing database so that only authorized personnel are allowed to make changes. Also, audit the more expensive material costs to ensure that costs are accurate. Further, restrict access to the unit of measure field in the inventory database; for example, if the unit of measure for a roll of tape costing $1.00 per roll is changed to inches (with 1,760 inches on the roll), the cost of the roll will suddenly increase from $1 to $1,760.
The Investment In Fixed Assets Is Increasing
What to do? Here are what to do:
. Compare assets purchased to the original budget. There may be nothing wrong with a rapid increase in the asset base, as long as the additions were purchased in accordance with the original fixed asset budget. Simply compare all purchases to the original budget, and verify that all authorizations are in place for everything purchased.
Controller’s recommendation: Institute a tight capital budgeting procedure to ensure that no assets are purchased that have not gone through the entire budget approval process. Also, verify that capital approval levels are low enough to ensure that the correct managers are affixing their signatures to the purchase orders for the bulk of the dollar volume spent on fixed assets.
. See if the depreciation method has changed. If someone has inadvertently altered the depreciation method being used, this can result in a significant change in the net value of all fixed assets. Review the fixed asset register to ensure that the same depreciation method is being used for all items within each fixed asset category.
Controller’s recommendation. Create an internal audit procedure for checking the depreciation method used for a sample of all fixed assets in the assets register.
. Verify that asset values are removed from the books when disposed of. Some companies have such poor accounting systems that there is no record of asset removals once they have been sold or otherwise disposed of. If so, the asset value on the books will be excessively high. To verify this problem, conduct an audit of the fixed assets and compare all items found to those listed on the accounting books.
Controller’s recommendation: Institute a procedure for properly removing all assets from the books of record once they have been disposed of. Also, institute a policy of conducting a fixed asset audit at fixed intervals that is designed to spot any asset dispositions that have not been properly recorded.
. Verify that only assets exceeding the capitalization limit are capitalized. It is possible that asset values are increasing because the accounting staff is incorrectly capitalizing assets that are too low in cost, and which should actually be expensed. Sample the fixed-asset register and verify that all recorded assets exceed the capitalization limit.
Controller’s recommendation: Implement additional training of the accounting staff to ensure that they do not capitalize items that are below the capitalization limit.
What to do when the revenue [sales] account is declining? What to do when funding supplied by accounts payable is shrinking? What to do when some costs and expenses is increasing? What todo when return on equity [ROE] is going worst? There are many more symptoms that financial managers, controllers and CFOs should aware and taken care immediately. I will keep posting such symptoms and solutions going forward. If you love those topics, you may want to keep watching and check into this blog often.
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