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Using Ratios to Find Hidden Income

Certain ratios can be effective tools in discovering hidden income. This is especially true where the income earner is living an expensive lifestyle but his or her reported income is inconsistently lower than that lifestyle.

Net Income Ratio

Assume that statistics show that the net income of typical doctors of internal medicine is approximately 50% of their gross receipts. That means that the ratio of their net profit to their gross receipts is 50%. Looking at the subject case, an internist with his or her own medical practice, one sees that on his or her tax returns the doctor reports net income that is 20% of his or her gross.

There are several reasons why that may be happening. One is that the doctor is a terrible businessperson, and his or her overhead is excessive, and so his or her profits are very poor. Another possibility is that there are many personal expenses being paid for by the business and being recorded as business expenses. Therefore, it may be that 30% of the gross is really personal income being disguised as business expenses. This net income ratio is therefore very helpful is directing one's attention to looking at the expenses to see if they are really business expenses.

Cost of Sales Ratio

Assume that statistics show that the cost of food sold by higher end restaurants is typically 60% of the sales price. In other words, assume that if a restaurant sells a meal for $50, not including drinks, the cost of the actual meat, potatoes, salad, etc. cost $30. The restaurant therefore makes a gross profit on the meal of $20, from which the owner pays rent, salaries, etc. Looking at the subject case, that of a high-end restaurant owner, one sees that on his or her tax returns, the owner reports sales of $3,000,000 with cost of sales at $2,500,000, which means that his or her cost of sales is 83% of his or her gross. It should be only 60%, using assumed statistics.

Again, there are several reasons why that may be happening. One is that, again, the owner is a terrible businessperson, and he does not buy well, and so his or her costs are higher than the industry. Another might be because food costs skyrocketed in the past year but the owner couldn't pass the costs to his or her customers. One then looks at prior years. If the pattern over the past few years is more or less the same 83%, then this explanation is probably excluded, especially if the news does not reflect a long period of skyrocketing food prices.

One then investigates to see if there are many personal expenses being paid for by the business that are being recorded as cost of sales. Sometimes there are fictitious vendors on the books, with the actual payee of the check being the owner.

Sometimes kickbacks are involved, where the owner pays a large amount of money for vegetables to his or her vegetable supplier, and the excess over actual costs is being given back to the restaurant owner in cash by the vegetable supplier. Part of the analysis required in cases like this are to review the paid bills, see if the vendors look legitimate, see the amounts of certain foods being purchased makes sense in light of the restaurant menu, look at the backs of the cancelled checks, etc.

In other words, one verifies that the expenses are real. If the expenses appear to be real, one investigates to see if all sales are being recorded. It may be that the costs really are $2.5M, and it may be that the costs are really 60% of the gross, and the real gross is therefore $4,166,667 (60% of $4.17M is $2.5M.). The unreported income would therefore be $1.17M ($4.17M projected sales less $3.0M reported sales).

This ratio is often described as the gross profit ratio, because the sales less the cost of sales is the gross profit, and so one could look at either the cost of sales ratio or the gross profit ratio to see that something is irregular. Using the above example, the typical gross profit would be 40% (since the cost is typically 60% in the example) and the subject case is reporting gross profits of 17% (since he reports costs of 83%). The fact that the subject is profiting so much less at the gross profit level compared to the norm is reason enough to pursue further investigation.

Horizontal Analysis

To do this analysis, one simply prepares a spreadsheet of the last few years of tax returns. Assume the subject case involves a shampoo manufacturer, and that water is 90% of the ingredients of the shampoo being made. Therefore, utility expense would be a major expense for this business, since they would be using a lot of water. One then looks at utility expense horizontally, looking at the expense in year 1 of the spreadsheet, then year 2, then year 3, etc. If utility expense keeps going up and sales are either flat or going down, then there are several possibilities that need to be explored.

The first is that maybe utility rates have gone up significantly. One then looks at the paid bills, compare the rates that were charged over the years, and one looks at the amount of water that was used. If the rates were more or less flat and the water usage went up, then theoretically, sales should have gone up. One then looks to see if the sales price per bottle/case has gone down, perhaps due to recessionary pressure. If the sales price per bottle/case has instead gone up, and the water usage has gone up, but reported sales has gone down, then one knows that further investigation is warranted. There is now reason to believe that some sales are not being reported on the books.

For some businesses, this horizontal analysis may not produce a clear path to follow up on, especially if the business is volatile in what it sells and the industry it is in. For other businesses, one would expect a very clear pattern. A laundromat, for example, should show utility expense that is quite consistent with its gross sales (that's the cost of sales ratio discussed above) as well as horizontally. If utility expense goes up, so should sales, since one of the largest expenses of a laundromat is utility expense. If, for example, one sees that the tax returns reflect decreasing sales with increasing utility expense, year to year, one starts the investigation with the utility expense.

Specific Expense Ratios

Many businesses have their own built in ratios for success. For example, people who are considering buying a restaurant are often advised that if the rent expense on the new lease will be more than 10% of the projected sales, the restaurant will not succeed.

Law firms understand that if secretarial and administrative staffing costs reach a certain percentage of gross billing, the success of the law firm is endangered. Therefore, when looking at a particular business or professional practice, one should first collect some basic statistics as to the typical ratios of that business, if possible.

If one expects rent to be no more than 10% of the total sales, and instead, one sees that on the subject tax return, it is 20%, then theoretically the business should be suffering. If, instead, the business owner exhibits signs of well-being, such as recent purchases of expensive personal clothing, a new lease of an expensive car, or a recent expensive vacation, then there is a strong possibility that the tax return does not reflect all of the real income that is being generated. One then zeroes in on how income is being received and recorded, to look for unreported income.

As another example, assume the subject case involves a small law firm, with one lawyer owner and two associates, and the associates are each earning more than the reported net profit of the lawyer owner. In this situation, the ratio being analyzed is the ratio of the associate compensation to the owner compensation. Assume further that the law practice does not do any contingency work, and so there is no expected balloon payoff that might accrue to the owner. One then needs to find out why the owner's compensation is so low. It may be that the owner never does any work, and instead plays golf all day, in which case an earning capacity argument can be raised.

Alternatively, it may be that some of his or her clients are paying in cash or barter, such as making payment in the form of expensive artwork. To resolve this, one needs to look at the billing and collections, and place close attention to the adjustments and write-offs.

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