ENGlobal Corporation - DSO Calculation Discrepancy

Rev. 1.2

*Beep* Houston We Have A Problem

This posting will cover a narrow scope issue attempting to verify the Company’s reported DSO calculations. All calculations use information included in the 2011 10K (4Q 2011) and 1Q 2012 10Q. There will also be a discussion of DSO theory and how companies can modify their own formula to achieve best practice. I addressed Days Selling Outstanding in earlier posts.

As you know DSO is an important tool in measuring liquidity and has become a quick metric whereby investors and readers of financial data judge a company’s cash flow.  Normally a DSO trend downward indicates a positive cash flow and vise versa a trend upward indicates a negative cash impact for the period being reported. Why is it an important parameter? The lower the DSO the less you have to borrow from the Credit Facility and pay the associated costs. If you look at most definitions for calculating DSO the formula will be:

“Accounts Receivable / Average daily sales = DSO”

Discussion and Best Practice Using Your DSO

Only including “Billed Revenue” in the Accounts Receivable (“AR”) numerator would seemingly only measure the effectiveness of a company’s collections process. If you were to also include “Unbilled Revenue” in the numerator and the DSO came out significantly higher then you may need to look at your “order-to-cash” process which would include generating invoices quicker after billable work perform is performed.  A company’s “Unbilled Revenue” includes cost plus billings and/or lump sum or fixed price billings. Unbilled lump sum/fixed price revenue is shown on the Balance Sheet as “cost-in-excess of billings” (“CIEB”). Timing can be an issue for “Unbilled Revenue” for Companies where cost plus charges billing cycles vary month-to-month due to a need to coordinate with something like bi-weekly pay periods. Getting those invoices processed prior to month end and thus included in AR may not be achievable due to timing.  Being late in billings for one day could mean current work would not get included in AR.  This further supports including these unbilled revenue in our numerator. Same logic could support including CIEB as this is earned revenue on fixed-price or lump-sum projects yet to be billed due to timing related to performance or contract terms, each of which should be in control of the company by meeting specific project deliverables or by negotiating more advantageous billing milestones.

What about “allowance for doubtful account” reserves, should they be added back? One could argue that bad debts are also controllable and should be included in the numerator and taking AR as a net figure. Lowering AR in this manner may distort DSO levels. Bad debts, or allowance levels, should also be in control of management be it though good credit practices, timely collections and/or performance issues which may lead to client refusals to pay. Adding back the allowance may help keep management accountable for these reserves.

And then there are “billings-in-excess of costs” which are shown as a liability on the Balance Sheet. That figure includes billings to customers which are not included in revenue because by contract a portion of the revenue included on the billing side has yet to be earned but that same contract allows for pre-billings to help match labor, material and equipment cash flow impacts. For cash flow, BIEC is a positive feature and can be controlled by management though contract negotiations and timely billing cycles.  To encourage such management practice and behavior why not give credit against the other items in the numerator for these excess charges? 

Confusing you say! Yes, and that’s the point. There is not one standard DOS formula that fits all and may not be a measurement of what each company is attempting to better manage. What should be standard though is that the same DOS formula is used period over period and that the DSO formula needs to be broadly understood and meaningful. Each company should design their own DSO method, which hopefully will fit their industry and give investors a quick benchmark to gauge the company’s success in managing liquidity and cash flow. 

Test your skills and try to calculate ENGlobal’s DSO levels comparing the financial results as of December 31, 2011 to their results as of March 31, 2012.  Just a hint, you will have to go back to the Form 10K for 2011 to get total revenue for the 4th quarter of last year.

	DSO	1Q 2012	4Q 2011
1	Revenues	75,440	76,097
2	avg days sales	838	846
3	DSO Calculated	78	69
	DSO Reported	61	70
	Balance Sheet	1Q 2012	4Q 2011
4	Trade AR, net	53,139	54,020
4	Add-back Allowance	1,713	1,792
4	Cost in excess	12,573	6,790
4	Note receivable	-	-
4	Billings in excess	(2,236)	(4,421)
5	Totals	65,189	58,181
	Trade AR, net	53,139	54,020
	Allowance for doubtful acct	1,713	1,792
	Cost in excess	12,573	6,790
	Note receivable	514	514
	Cost in excess	2,236	4,421

Notes to line items: 1. From forms 1Q 2012 and 10K 201; 2. Revenues divided by 90 days; 3. Item 5 divided by Item 2 avg days sales; 4. From forms 1Q 2012.

Conclusions

Let’s put these numbers into perspective. Read this statement taken from 2012 Form 10Q for period ended March 31, 2012, page 17:

“The Company manages its billing and client collection processes to reduce days sales outstanding (DSO) to the extent practicable. We believe that our allowance for bad debt is adequate to cover any potential non-payment by our customers. The Company's DSO decreased to 61 days at March 31, 2012, from 63 days at March 31, 2011, and 70 days at December 31, 2011. Both decreases in the number of days of sales outstanding were primarily attributable to efforts to collect accounts receivable from clients whose payment practices are slower or whose payment terms are longer compared to the Company’s average payment terms. ENGlobal continues to manage its billing and client collection processes toward reducing days of sales outstanding to the extent practicable.”

I think by now you can see the discrepancies. First, and not the big issue is the DSO for 4Q 2011 actually looks 1 day better than reported. This is not such a big deal but a positive difference nevertheless.

I believe you understand that DSO management makes incremental changes over time with good accounting management. What really catches the eye is why DSO was proudly reported coming down from 70 days to 61 days! Looking at the numbers included in recent SEC filings and making same application formula calculations shows this 61 days DSO is a grossly false number, or the Company has some secret DSO formula applied inconsistently over the two periods. Moreover, DSO has seemingly actually deteriorated, increasing by 8 days to a 78-day level as opposed to going down by 9 days!

I’d like to know what happened, wouldn’t you? Why was 61 days DSO reported when it is actually closer to 78 days? If you just used net AR straight from the March 31, 2012 Balance Sheet as your numerator you get 63 days DSO ($53,139 mil / $838k). Where are the auditing backup procedures to catch “mistakes” like this? There are many things all companies need, publicly traded or not; a fundamental element is the need to be trusted. Two following imperative traits a publicly traded company needs are clean consistent numbers and transparency. We have been seeing more and more numbers that do not pass the smell test as illustrated in recent posts. When is management going to be held accountable? 

Good luck to everyone.

Comments are welcome.