I made a profit--but where'd the cash go?

Motor,  Dec 2001  by O'Connor, Bob

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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 goP'

ur 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 11 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 aheadthe 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. Let's review the financial statement of Joe and Terri's repair shop and see if we can determine where the cash is going. Methods of Accounting There are basically two recognized methods of accounting-accrual and cash. Most accountants prefer and recommend the full accrual method in accordance with generally accepted accounting principles. But most auto repair shops don't have the expertise on staff to implement full accrual accounting, and most can't afford to pay an outside firm to provide the service. Therefore, more often than not, most use some accrual methods and some cash methods, which results in a relatively accurate financial statement. However, the practice of combining the two often leaves some holes that can create significant problems.

Financial statements consist of three major components-a Statement of Income, a Balance Sheet and a Statement of Cash Flows. We'll explain what they are and why they're important, then see how they relate to Illustrative Auto Repair's situation. Income Statement. The first element of a financial statement is the Income Statement. Illustrative Auto Repair's Income Statement (shown above) reflects the shop's total sales, cost of sales, expenses and, finally, the total earnings for the first six months of 2001. Most repair shops produce or obtain an Income Statement on a monthly basis. Note that this shortened version of the Income Statement for Illustrative Auto Repair shows net income for the first six months of 2001 to be $5711.90 after taxes. These earnings are meager-only slightly over 3% of sales; however, they do represent a profit instead of a loss. Balance Sheet. The second element of a financial statement is the Balance Sheet. Most repair shops produce or obtain a Balance Sheet also on a monthly basis, just like the Income Statement. Referring to Illustrative Auto Repair's Balance Sheet (shown on page 59), note that the first section shows its current assets, which encompasses cash in the bank, accounts receivable and inventory and makes allowance for bad debts. The shop's total current assets comes to $24,639.17.

"Allowance for bad debts" means that prior to the start of a new year, a method of handling bad debts is elected. In this instance, the allowance for bad debts is calculated using prior bad debt experience and takes into account customer receivables that are over 90 days old. The current provision is 1% of the accounts receivable at the reporting date.

The next section of the Balance Sheet covers property and equipment, which is often referred to as fixed assets and includes items such as furniture, fixtures and equipment. Adding total current assets and property and equipment (after depreciation), results in a total assets figure of $45,580.21.

The third section of the Balance Sheet lists current liabilities-items that must be paid out when sufficient cash is available. In this instance, the total is $31,503.01, and Illustrative Auto Repair doesn't have enough cash in the bank, even if it collected all of its accounts receivables. So information that would help determine where the cash is going could be ven, valuable to Joe and Terri, as it would enable them to make good business decisions.