Diagnosing a Business from its Statements

We are more profitable than we have ever been, and I cannot seem to pay payroll.

We are making profits, but I cannot even pay my workers on time. What is the problem here? We are more profitable than we have ever been, yet at the same time I am having problems making the deadline of getting payroll paid. What could be the problem?

That is the kind of question this section is for. We have all the tools now. What we have not done is use them all at once, on one business, in an order that gets somewhere.

What we are looking at

We have a business that grew revenue at 32 percent, and it improved its gross margin every single year. For some reason it had to nearly double the amount of debt it had, its bank loan, just to stay open.

What is going on here? How is that possible? Something feels like it is going wrong, and it is worth diagnosing.

From a gross margin standpoint, it means you are profitable on selling product. So something is going wrong with profit somewhere else. If we apply the DuPont decomposition, something is going wrong with profitability and it is below the gross margin line, so it has got to be an operating profit problem, or debt.

Another thing it could be is efficiency. Perhaps we have got a bigger business growing, but we are not as efficient, and that is why we need an infusion of cash.

What is going on here is that we need a diagnosis, to see if we have got a performance problem or a liquidity problem with this business, and to make sure that we get it on the right track.

The operating expenses, and a double click

I said we have to look at the operating expenses. Look at that table and let us do a double click. What has really changed, and what is a big number?

Expenses went from 60,000 to 108,000. Something needs to explain that - huge growth, given that revenue only grew 32 percent.

Here is what is inside the operating expense line.

For the years ended December 31. All figures in dollars.

It turns out that payroll is the biggest issue. It is the biggest number with the biggest jump. Total payroll ran 36,800, then 53,500, then 76,600 - an index of 100, 145 and 208, against revenue at 132.

The fact that the owner is taking her salary out at a significantly higher number is really hurting the profitability of this business.

Notice what just happened. We got from the financial statements to an operating decision that was made, and that decision helps us drive the result.

Was she right to do it?

We know that it is eroding the profitability of the business. But is this right? Should the owner’s salary be this high? What does this number compare to, and what do we think is right?

Any time you are raising a salary by 62 percent when the business is only growing 30 percent, it looks kind of sketchy. On the other hand, she is running a half-a-million-dollar business, and $55,000 in salary does not feel like very much.

Does this explain the financial deterioration against pretty standard metrics? I would say absolutely.

Is this salary right? Was she being underpaid up front and now she is finally being paid at the right amount, or is she being overpaid? That is a bit of a judgment call. Part of it is that we can compare it to what a typical person would earn in this business. And we have to compare it to what she needs - perhaps she needs it to basically fund her life, and this is necessary.

But there is something that stands here. This is a primary driving factor of why the financials of this business are not looking good. You cannot grow an expense this substantial by over 60 percent when the business is only growing 30 percent and not have consequences. We are finally able to land on what is going on.

The efficiency story

Whether or not this person deserves a salary of $55,000, we know what the impact is going to be on the business. But there are other things that we can look at in here, namely efficiency.

The story is:

• Days inventory outstanding goes from 78 to 97 days.
• Days sales outstanding goes from 47 to 60 days.
• Days payables outstanding goes from 45 days to 49 days.

Cash conversion - from the day we put out our first dollar to the day we collect it - goes from 80 days to 109. What is happening inside this business to make the numbers move like that?

Let us walk through the calculations. We should use average balances, because we want to compare an income statement number with a balance sheet number. We can only do this for 2021 and 2022, because the first year has no prior balance to average against.

If we want to convert that into days, we first figure out the turnover ratio. For inventory turns, it is cost of goods sold divided by average inventory. If we want to talk about days, we take 360 and divide by that turnover. The same calculation exists for the receivables turnover, because that is just revenue divided by average accounts receivable, and for payables it is cost of goods sold divided by average payables. To convert these into days we take 360 and divide by those turnovers.

Now if you take all that, you can add up the days inventory outstanding, the days sales outstanding, and the days payables outstanding, and you can see that we have gone from about 80 days of cash conversion cycle to 109 days.

We can break this down and ask what is going on here. From an inventory standpoint, inventory sat around on average 20 days longer. Customers took 13 more days to pay. And the business took 3.6 days longer to pay its own suppliers. Everything is just kind of slowing down.

What 29 extra days costs, in money

What are these 29 extra days costing us in money?

Revenue runs at about $1,467 a day. We get that by taking all the revenue divided by 360. The cycle is roughly 29 times $1,467, which is $42,500 of cash that has to sit inside the business rather than in the bank.

Now, the loan went up. That is how much we have to have in our business. Our loan went up $36,000 that same year.

That is the connection. The cash conversion cycle is not just a formula, it is a reason. When all of this stuff starts taking longer, we need to have more money in the business to keep this going. It turns out that those extra cycles are costing us around $42,500, and that is why we need to take that extra loan of $36,000. That all makes sense.

A growing, profitable business can run out of cash, because when you grow, that means everything is getting bigger. We are selling more stuff, but it probably means we have more receivables. Maybe we have more payables. We have to have more inventory to satisfy greater demand. What that means is that as it gets bigger, we need to have more invested in the business to generate that return. If you do not have the cash to fund that, you either have to borrow it, or make the operations leaner so we can generate more cash and the business can fund itself.

The trap

Let us keep drilling down. What is the trap here?

The current ratio has improved every year. It was 3.38 in the first year, then 3.44, then 3.55. This feels like it should be getting better. But cash is falling from 40,000 to 13,800, and the loan nearly doubles.

The typical measure of liquidity would suggest that we were doing well, and we are actually doing worse. Can we get a better measure of what is going on? What is that current ratio actually counting?

The current ratio has gone up from 3.38 to 3.55 in 2022. The quick ratio also does not look that bad - we have gone from 1.96, where we are taking the current assets, taking out the inventory, and dividing by current liabilities. Here it is going to be mostly cash and receivables, and that feels like it is going pretty well.

The issue is when we look at the cash ratio, just cash as a percentage of current liabilities. We see this going down a lot.

What is going on here? The quick ratio does drift down. The current ratio is looking fine. But the reason for all of this is in the mix. Inventory grew 64,000, receivables grew 56,000, and cash fell 26,200. While the numerator of the current ratio is growing, the two assets we cannot pay bills with - inventory and accounts receivable - are really driving that growth. Instead of cash, we are counting the problem as if it is a measure of something good for performance.

And the quick ratio does not save you here. We take out inventory, thinking that is not converting to cash real quick. But that does not help us if our receivables collections are out of whack. Taking the inventory out is not strict enough, because receivables are the other half of this bloat, and receivables are going up while our cash is going down. Our quick ratio would suggest that things are just fine. They are not, because cash is going down.

Once again, we need to measure cash, and monitor cash, and manage cash as if it is the oxygen of the business.

So when it comes to liquidity ratios, we are not just talking about the strictest test. Every liquidity ratio is only as honest as the assets in its numerator, and the only way to know whether to trust it is to know what is in there. The cash ratio is the barest bones, and it is not one of the four families we talked about, but it is worth taking a look at and knowing about.

Liquidity ratios can hide a lot of things. If we are looking at quick ratios, we are just taking cash plus accounts receivable. What it can hide is that we are running out of cash, because even though that ratio looks good, what is happening is that we just have too many receivables. A current ratio includes inventory. That can hide even more, because we are conflating inventory, accounts receivable and cash, and it can in fact hide that we do not have enough cash to pay off bills.

When you want to look at cash at the end, you have to look just at that: cash as a percentage, or the cash flow statement, and really get into those details. When we start combining these in numerators, it can start obfuscating things.

Leverage, and what the loan bought

Let us look at leverage.

Debt to equity goes from 0.97 to 1.01 to 1.33. Interest coverage goes from 5 to 6 to 3.1. The loan went up 48,000 over two years. What did that pay for? Is this a good use of borrowed money, if you were a banker? What should the bank do at the next renewal, when coverage is 3.1 times and we are seeing a dwindling capability for this business to cover its interest payments?

In 2021 debt to equity crossed the 1.0 barrier, and it kept on going. Now the business owes a third more than the owner actually has in it. That was not true two years earlier.

The interest coverage ratio has halved, from around 6 to 3, because the two halves of that ratio moved in opposite directions. Operating profit fell from 28,000 to 20,000, and the interest bill rose from 4,650 to 6,550. Those are two things going badly for us at once. Ratios move hard when the denominator and the numerator both work against us.

Note here that the borrowing rate, the rate of interest, never changed. It was 8 percent on the average balances in all three years. The fact that we have more interest is not because interest rates went up - and they often do when you take on more debt - but because we are taking on more debt.

When we are only making enough to cover our interest three times, there is a very good chance that we are not going to be granted any more debt moving forward. That is starting to get really risky to our creditors. They are going to see that and say, this business has got enough debt, we cannot give it any more without being unsafe.

So we got some more money. What did this buy?

First, working capital. We need money just to make this place run, to keep the lights on. Operating working capital is receivables plus inventory minus payables minus accrued expenses, and that is how much operating working capital we have. In 2020 it was 67,000. In 2022 it was 162,800.

Here is a table of where the money came from and where it went, over the two years.

From profits kept in the business, we took all those profits and got about 27,600. We have to add back the depreciation, because that is non-cash. Then we took on some new borrowing, an additional 48,000. And the cash went down.

If we add all this up it is 124,800. We have to figure out what happened with this cash. If we look at where it went, our increase in working capital went up 95,800, and then we did buy some equipment, which was an investing activity, 29,000. This is where it ties out.

When we do the reconciliation, what happened to this cash is brutal. The business generated 50,600 of cash from its own operations - which is 27,600 of profits plus 23,000 of depreciation we add back - and we had to put 95,800 into working capital. That means everything we earned, and then some, had to go into our inventory stock and unpaid invoices. We had to borrow that 48,000 and then spend down some of our excess cash just to make it.

So I would take that loan. Where did that loan get us?

Here is the bad news: nothing the customer cares about. It did not help us buy a second van. It did not help us get a bigger unit. It did not help us make better systems. The $29,000 in equipment spending came right out of depreciation, with room to spare.

It bought us the ability to have stock sitting on the shelf and invoices waiting to be collected. When bankers see that, they are not happy. This is not financial performance where we are creating value for a customer and growing. This is a business getting slow, fat, dumb and happy, and we are financing it. That is not something that is going to be taken very well.

Who cares?

Let us talk about who cares. Who cares? We should all care. This is a report card on a business. And there are multiple who-cares.

Bankers should care. We should be finding performers and putting our money there, because that is going to get us the best, safest return. They are especially interested in leverage ratios, to make sure you are not too risky to loan to. Sometimes they will even use maintaining a certain leverage ratio as a condition for having a loan.

Managers and owners should care. We want to use assets well and efficiently. We want the business to perform, to attract, and to be a place where bankers can invest safely with us. We want to demonstrate to them our performance. Managers and owners want insight into how their business is performing - not just good or bad, but why. What is driving good or bad performance?

Suppliers who sell to you on credit should care. We want to make sure that we are doing business with businesses that are running well, because businesses that run well are businesses that survive, and businesses that survive are businesses that pay their invoices. Suppliers do not like to deal with flaky businesses that might go out of business someday, because that puts their own business at risk. They might want to evaluate your liquidity ratios.

Of course, investors are interested in all these ratios, since they are hoping they are invested in a sound business.

There is no one magic ratio

Here is the thing: calculating ratios is easy. Coming up with meaning and a story, that is harder. You need to understand what comparisons to make. It is always compared to what? From that we can create meaning that leads to a good diagnosis and a sound prescription of what to do next.

Remember this about ratios - calculating them is easy, but meaning only comes from comparisons, over time, and against peer businesses. Also, a savvy analyst looks at multiple ratios and synthesizes a comprehensive picture.

There is no one magic ratio. There is not just “calculate this, see this, make a decision.” Great analysts are going to compute lots of ratios and put those puzzle pieces together into one coherent picture of what is going on, and how that leads to a prescription of how we can do better the next time.

Perhaps you improved profitability at the cost of asset efficiency. Maybe your return on equity is good because you are a better operator - maybe it is because you just took more debt exposure. Always take a holistic approach with these analytical tools. It will provide you with better insight into understanding performance and how to improve it.

All numbers tell a story, and putting what you know in context helps you to uncover that insight.

So what should she do?

What are the things a business owner has to do differently?

First thing, right off the income statement. Nice job growing your business, but the operating expenses are out of control. We have to make the hard choice of whether we have to grow this business and its performance even better to justify the salary, or take a reality check and bring this salary down, because operating expenses are killing us. The biggest one with the biggest move is the salary. If we are going to justify this salary, we are going to have to have a much bigger, much better operation to justify it - or be faced with the fact that this business’s performance does not look good.

Efficiency is also a big thing. We are growing but we are running out of cash. Every business that grows is going to need cash to fund it, but we could do better here. The amount of slack that we have in the system - waiting on collecting invoices, and inventory not moving - is creating a real big drain. We had to borrow money, and with borrowing money comes the risk of having to pay it back, along with the extra cost of higher interest expense. The other thing that we can do to lean this out is that we have got to collect on our invoices faster, and we have to turn this inventory quicker.

Lastly, leverage. Leverage is not buying us the right to grow. Leverage is buying us the state of being lazy. So the two things to do are both: we have to increase our efficiency and get our working capital in order, and at the same time lower our dependence on debt.

That is going to do several virtuous things. We are going to have less interest expense, which means we are going to be more profitable. More profitable means we are going to have more profits to cover an even smaller burden of debt. We are going to look like a better credit risk, which will help make this business both safer and more profitable.

The idea is to improve operations and profitability while at the same time lowering our dependence on debt.

© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.