T2 2021

Unit Code: HI5020

Unit Title: Corporate Accounting

Individual Assignment: Cash flows statements

Submission date:

Name:

Words Count: 3050 (excluding Abstract and References)

Abstract

Cash flow statements are becoming increasingly important among investors and lenders as a means of determining the financial strength of a company. Cash flow statements are a summary of the sources of cash and the uses of funds for each category in a business. The cash flow statement differs from the income statement in that the cash flow statement always complements the income statement and provides important information that is not otherwise available in the income statement. The sources and uses of funds are summarised in the cash flow statement under three main areas, which are operating, investing, and financing, respectively. The operating and finance sections of the cashflow statement would be of greater relevance to an equity investor or a bank lender. As a result, it is critical to comprehend the cash flow statement, including how and why it is relevant in the present context.

Table of Contents

Introduction

The cash flow statement is divided into three primary components, each of which highlights the circulation of cash as of the current date for the company. These are the ones:

Operating cash flow: This metric depicts the sources and uses of funds generated by the company’s core activity (Farshadfar and Monem, 2013, p113(4)).

Financing cash flow: It depicts the sources and uses of funds as a result of the company’s capital structure choice (Duncan and Helmi, 2019, p13(1)).

Investing cash flow: Funds derived from sources other than operating and financing operations are represented by the term “investment cash flow” (Duncan and Helmi, 2019, p13(1)).

Throughout this project, pupils have looked at a variety of different components of the cash flow statement, will learn about the different components of a cash flow statement, the difference between income and cash flow, how to evaluate a cash flow statement, as well as how to reconcile operational cash flow and net income. In this assignment, it has also been discussed how improperly structured managerial remuneration can have a negative impact on the health of a company’s bottom line.

Question 1

a) Preparation of cash flow statement

Statement of cash flow for Aggressive Corporation:

Statement of Cash flow (Amount in $)
Particular	Details	Details	Amount
Cash flow from operation:
Net income		30000
Adjustment for –
Depreciation	10000
Increase in receivable	-60000
Increase in inventory	-40000
Increase in accounts payable	20000
Increase in interest payable	10000
Net adjustment		-60000
Cash flow from operation			-30000
Cash flow from investing:
Equipment		-100000
Cash flow from investing			-100000
Cash flow from financing:
Note payable		100000
Common stock		40000
Cash flow from financing			140000
Net increase in cash			10000
Beginning cash balance			0
Ending cash balance			10000

According to the cash flow statement, the final cash flow balance is $10,000. The primary source of funds comes from the financing activities, whereas the cash flow from operations and investment is negatively correlated.

b) Net income vs operating cash flow

It is conceivable that a company’s net income is positive, but that the company has negative cash flow. This is due to the fact that income statements are generated using the accrual method of accounting, but cash flow statements are prepared using the cash movement method of accounting. Aggressive has a positive income of $10,000 but a negative operational cash flow of $-30,000 in the example shown. The following are the primary reasons:

Investment in a current asset:

A total of $40,000 has been invested in inventory, with an additional $60,000 in accounts receivable. These are two current asset items that have not yet been converted into cash due to the fact that the cash conversion cycle may require significant period to accomplish. To put it another way, the full transaction is not in cash, and Aggressive has not yet received payment from its debtor. As a result, while estimating operational cash flow, these items are subtracted from net income before being included.

Non-cash item:

Due to the fact that depreciation is a non-cash item, it will be adjusted to net income in order to arrive at a cash flow from operations.

Current liabilities change:

The firm has seen a rise in current liabilities (interest due and account payable), which are obligations that have not yet been satisfied. To get at operational cash flow, the rise in current liabilities is adjusted to net income and the result is net income plus current liabilities.

Positive adjustments for current assets are greater than negative adjustments for depreciation and current liabilities in the instance of Aggressive Corporation, resulting in negative cash flow for the company.

c) Negative operating cash flows affecting reliability of net income

When considering whether to invest or lend money, an investor or borrower will consider both net income and operating cash flow (Curley, 2008, p56(1)). The amount of cash created by a company’s primary operations is represented by its operating cash flow. When compared to net income, operating cash flows give a more accurate picture of a company’s ability to produce cash flow. If a company’s operational cash flows are negative, it will not be able to fulfil its debt and interest commitments on time. The company’s long-term viability and capacity to continue operations will be called into doubt. Negative operational cash flow is one of the early indicators that a company is on the verge of going out of business (Dalir Rezagholi Gheshlaghi, Ahmadzadeh and Faal, 2014, p15(11)).

A company that has had persistent negative cash flow over a long period of time will not be able to exist and will be forced into financial difficulty. While it is not uncommon for a company to have a positive net income but a negative operating cash flow in the early stages of its existence, this attracts the attention of lenders who scrutinise the situation before making any financing decisions.

It is an unsettling scenario when it comes to confidence in net income, and the company must take reasonable efforts to enhance operating cash flow.

d) Potential employment position and influence on loan decision

Following the disclosure of the information, it is apparent that Matt is not happy with the approval of an extra loan balance of $50,000 after experiencing negative cash flows. He also recalls a recent cash failure by another bank, which occurred as a result of the bank’s inability to generate positive cash flows. In order to have the loan authorised by Matt, the CEO has provided Matt with a statement on a future employment position. Larry is only attempting to persuade Matt to accept the loan deal by offering him the post of CFO. Larry has offered Matt something that might be described as a bribe in certain ways.

The decision to provide the loan is influenced by the possibility of future work opportunities. That is why Matt needed an additional two weeks to respond to Larry’s email. The bank employee and loan approval officer Matt should maintain his independence while assessing loan applications and should adhere to professional ethics and a code of conduct when carrying out his job responsibilities. Such types of actions will result in financial fraud, which should be avoided at all costs and should be reported to the relevant government agency.

Question 2

Preparation of memo for the management of Polar Opposites

To, The management of Polar opposites Subject: Explanation behind negative operating cash flows and positive income. Background: Polar’s net income for the period ending December 31, 2018 was $5 million, but its operational cash flows were a negative $5 million as of December 2018. Polar has completed its first year of business. In this document, the attempt was to explain the circumstances that led to this scenario. The income statement and the statement of cash flow are two of the three fundamental financial statements. In the income statement, the specifics of the profit or loss made during the period are shown in detail. The cash flow statement displays the specifics of cash in and outflows depending on three different activities (Dalir Rezagholi Gheshlaghi, Ahmadzadeh and Faal, 2014, p15(5)). These are the activities: Cash flows from operating Cash flow from financing Cash flow from investing When it comes to business, cash flow from operational activities indicates the sources of cash and the amounts of money that are spent on the company’s primary operations (Dalir Rezagholi Gheshlaghi, Ahmadzadeh and Faal, 2014, p16(1)). For want of a better expression, it indicates how much cash the company has produced through its core business or operational operations. The more the cash flow generated by the company, the better the financial health and liquidity of the company. This year, Polar has recently finished its first year of operations, which resulted in a net income of $5 million and a cash flow from operations of -$5 million. The following table illustrates the statement of operational cash flows calculated using the indirect method: Statement of Cash flow (Amount in $) Particular Details Details Amount Cash flow from operation: Net income   5000000   Adjustment for –       Depreciation 4000000     Increase in receivable -16000000     Increase in inventory -14000000     Increase in accounts payable 7000000     Increase in accrued payable 9000000     Net adjustment   -10000000   Cash flow from operation     -5000000 It appears to be unusual because, while income is positive, cash flow from operations is negative at the same time. This is owing to the fact that the income statement is prepared using the accrual method of accounting, which differs from the cash flow statement in this regard. It can be seen from the above table that the company has a significant amount of current assets- Receivables totalling $16 million: This is the total number of credit sales for which the collection of money from the debtor is still pending. It is normal that out of the 65 million dollars in sales that were made during the year, 16 million dollars are in credit and have not yet been paid out. Inventory valued at $14 million: This represents the quantity of inventory that the company has at the end of the year. It will enhance operational cash flow after it is sold and collected, which will occur when it is sold and collected. There have also been additional changes to the net income, which have resulted in an improvement in the cash flow from operations (Increment of current liabilities). In addition, depreciation is a non-cash item, which means that there is no movement of cash, but depreciation is an expenditure that is charged to the income statement in order to account for the ongoing wear and tear on fixed assets (Li, 2016, p1(2)). The factors listed above are the primary reasons why a company’s cash flow from operations is negative. Additionally, in order to run a firm effectively, it is required to invest a certain amount in working capital (current assets other than cash). Often, a company must make credit sales, but it must also ensure that the money is collected from debtors on time and within the credit period that has been extended to them. It is not an unusual position, given that the company has just finished its first year of operations and has a substantial quantity of current assets, resulting in negative operational cashflows.

Question 3

a) Cause of increase in receivable and its impact on net income and cash flow from operations

When a company sells its products or services, it has the option of accepting payment in cash or credit. If the product is sold on credit, the company will have an account receivable in its books, which will display on the current asset section of the cash flow statement (Li, Teng and Zheng, 2019, p378(2)). In general, the business will collect cash from the debtor in the future in accordance with the credit term, and it will display a rise in cash and a decrease in debtor once the money has been collected.

General Electronics is now in a precarious position. The Brayan Group has discovered that the firm has eased its credit conditions, loosened its credit policy, and prolonged the credit duration, which has resulted in an increase in the account receivable amount. These are the primary reasons for the large growth in account receivable that the company is experiencing.

Every company establishes its own credit policy, which outlines the standards for determining a debtor’s credit worthiness as well as the length of time that the debtor will be granted credit for. The debtor’s financial health is taken into consideration while making an assessment. This implies that if one company’s financial health is in poor shape, it is not a good idea to sell our goods on credit to that particular company. The risk of selling a product on credit might be taken on the other hand if the financial condition of the other company is solid enough. It has been discovered that GE is not adhering to its credit policy as strictly as it should and has even lowered its standards. This indicates that the company is taking a greater risk of selling its goods on credit to a client who is in a difficult financial situation.

Credit terms refer to the number of days that the debtor must to make payment on the invoices that have been issued (Li, Teng and Zheng, 2019, p378(2)). According to the information provided, GE has loosened its loan terms. This implies that if the initial business established a credit period of 30 days, and the credit period has now been increased (suppose 40 days), the account receivable will have increased.

Another motive for increasing the credit period is to increase the amount of money owed. This indicates that not only has the company loosened its credit policy and increased its credit conditions, but it has also prolonged its credit duration beyond the number of days previously agreed upon, resulting in a greater amount of money receivables to the company.

Accounts receivable are increasing, which indicates that the company is selling more of its products and services. This translates into more revenue and, consequently, higher operational profitability. Increased account receivable, on the other hand, will result in a reduction in cash flows from operational operations. This is due to the fact that just the circulation of cash is reflected in cash flow. Because of the increased receivables, they will have greater income but weaker operational cash flows as a result.

b) Executive compensation and risk of earning management

It is possible that executive remuneration for officers such as the CEO and CFO may raise the danger of earning management in the future. To compensate its highest-ranking officials, the company now pays remuneration based on the net income shown on the income statement. In the situation under question, the company’s net income has increased over the previous three years, but operating cash flows have decreased year on year during the same period. However, it has been observed that the firm’s capacity to obtain cash flows from its accounts receivable has been deteriorating over time, which is not in accordance with best practises. Performance of pivotal managerial personnel is managed in accordance with net income reported on the income statement.

Because managerial pay is dependent on net income, management may choose to take on access risk by selling a substantial amount of merchandise to a client who is already experiencing financial difficulties. Although the likelihood of collecting money from such a client is unlikely, the officer’s supervisory compensation would have grown as a result of higher sales and net revenue.

An unethical management remuneration plan is detrimental to the success and profit of the organization. Because it pushes managers to take greater risks, it may have a negative impact on long-term sustainability.

c) Trend of operating cash flows and other even, cause of concern

The following table depicts the trend in operating income, net income, and operational cash flows during the last 4 years:

Amount in $ million
Particular	2018	2017	2016	2015
Operating income	1,400	1,320	1,275	1,270
YOY changes in operating income	80	45	5	—
Net income	385	350	345	295
YOY change in net income	35	5	50	—
Cash flows from operations	16	110	120	155
YOY changes in operating CFs	-94	-10	-35	—

In light of the data in the preceding table, it may be concluded that net income is growing year over year, but cash flow from operations is decreasing year over year CFs from operations are just 16 million in fiscal year 2018, compared to $155 million in fiscal year 2015. When it comes to long-term sustainability, operating cash flows are an excellent predictor, but net income is not. The income statement contains a large number of noncash items and, as a result, does not accurately depict the company’s liquidity position. A larger net income does not imply a better level of liquidity for a company. Based on the current pattern, it appears that the fiscal year 2019 will have a negative operational cashflow.

Bryan’s concern about the pattern in the income statement and the trend in operating cash flow is well-founded. This situation needs quick attention from senior management in order to resolve it.

d) Course of actions

Following an examination of the financial trend and other findings of Bryan, the following measures should be done to mitigate the damage:

Increase the rigour of the credit policy:

Before extending credit to a client, the company should adhere to a tight credit policy and conduct a thorough assessment of the customer’s financial situation (Cui, Hastak and Halpin, 2010, p362(5)).

Reduce the length of the credit period:

It is anticipated that reducing the loan duration will result in more rapid recovery of cashflow from debtors (Cui, Hastak and Halpin, 2010, p366(5)).

To take legal action against the defaulter:

The company should pursue legal action against the consumer who has failed to meet their obligations.

Putting cash discount on sales is essential.

Firm should provide a cash sales discount, which will result in increased sales, as well as prompt collection of cash from sales, which will result in improved operational cashflows for the company.

Compensation for management:

Management compensation must not only be connected to net income, but it should also be related to operating cash flows to ensure that it is effective. This will help to maintain a healthy balance amid net income and cash flow.

Conclusion

In this task, the attending learnt how to construct a cash flow statement, as well as how to analyse it and reconcile it with other financial statements. The case study of Aggressive Corporation has helped to grasp the difference between net income and cash flow from operations, as well as why it is so critical to have positive and rising operational cash flow in order to be successful. The case of General Electronics has helped the attending comprehend how a company’s net income may continue to grow although the company’s operating cash flow may be in negative territory. In addition to focusing on net income, management remuneration should be connected with cash flow, primarily positive operational cash flows, to ensure that it is effective. As a result of the research, the attending conducted for this project, one may get a fundamental grasp of cash flow and the significance of cash flow.

References

Cui, Q., Hastak, M. and Halpin, D., 2010. Systems analysis of project cash flow management strategies. Construction Management and Economics, 28(4), pp.361-376.

Curley, M.T., 2008. Margin trading from A to Z: A complete guide to borrowing, investing and regulation (Vol. 352). John Wiley & Sons. Available at: https://www.arabictrader.com/cdn/application/2009/11/11/pdf/v202/CAF9A80F-B300-B609-728E-E6DDEB1B2D81.pdf.

Dalir Rezagholi Gheshlaghi, F., Ahmadzadeh, Y. and Faal, F., 2014. The cash flow statement’s component effect on management performance in firms enlisted in tehran stock exchange. UCT Journal of Management and Accounting Studies, 2(1), pp.14-21. Available at: https://www.sid.ir/en/VEWSSID/J_pdf/5075820140104.pdf.

Duncan, S. and Helmi, A., 2019. Cash flow management: case AINA Wireless. TURKU UNIVERSITY OF APPLIED SCIENCES THESIS, pp. 1-41. Available at: https://www.theseus.fi/bitstream/handle/10024/267462/Duncan_Shaun_Helmi_Antton.pdf?sequence=2&isAllowed=y.

Farshadfar, S. and Monem, R., 2013. Further evidence on the usefulness of direct method cash flow components for forecasting future cash flows. The international journal of accounting, 48(1), pp.111-133. Available at: http://site.iugaza.edu.ps/malashi/files/2018/09/IAS7-P1.pdf.

Li, N., 2016. Adjustment for Non-Cash Items in Earnings-Based Covenants. Available at SSRN 2875413. pp.1-45. Available at: https://poseidon01.ssrn.com/delivery.php?ID=255100081087115083120114118008000023016039060039010087100112100070068088029103073022019117103061008030027113117022097097090079043075078051054006007108028104092127105003079016087008088020103016122094000123006004097077076011067125074121123081103091001027&EXT=pdf&INDEX=TRUE.

Li, R., Teng, J.T. and Zheng, Y., 2019. Optimal credit term, order quantity and selling price for perishable products when demand depends on selling price, expiration date, and credit period. Annals of operations Research, 280(1), pp.377-405. Available at: https://link.springer.com/article/10.1007/s10479-019-03310-2.

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