ABC Corp. Statement of Cash Flows for 2010
|Cash Provided or Used|
|Adjustments Due to Changes in Working Capital:|
|Increase in Accounts Receivable||($12,500)|
|Increase in Inventories||($15,000)|
|Increase in Accounts Payable||$1,500|
|Increase in Accrued Payroll||$1,000|
|Net Cash Provided by Operating Activities||($2,000)|
|Cash Used to Acquire Fixed Assets||($8,500)|
|Sale of Short-Term Investments||$2,000|
|Net Cash Provided by Investing Activities||($6,500)|
|Increase in notes payable||$3,500|
|Net Cash Provided by Financing Activities||$3,500|
|Net Change in Cash||($5,000)|
|Cash at Beginning of Year||$12,000|
|Cash at End of Year||$7,000|
Previously, we introduced readers to the third and final of the three major financial statements, the statement of cash flows, and produced the above-referenced example for our fictitious ABC Corporation. Now it is time to do some financial analysis to see what the statement of cash flows has to tell us about the all-important cash position of a business.
At the conclusion of our previous post we mentioned that one of the entries on the statement of cash flows may very well be the most important figure on any of the financial statements. So without further ado, let’s reveal what that figure is and why it is so important. The object of our scrutiny is: net cash provided by operating activities.
While you might thank that net income (i.e. profits) would be more important as it is the famous “bottom line” number from the income statement—and a favorite of the press when discussing a company’s financial results—savvy investors, and business owners, prefer to focus on net cash provided by operating activities.
Net income can be subject to distortions—either intentional or unintentional—through tactics like not properly recognizing bad loans or misrepresenting the value of assets. Because it is much harder to misstate profits and working capital, it always pays to look at net cash provided by operating activities, which reflects the effects of changes in working capital on a firm’s net income. There are many examples of companies that have reported positive net income even when they are on the brink of declaring bankruptcy; in almost all of these cases though, net cash from operating activities began to deteriorate much earlier, providing an early clue that the firm was in trouble.
In the case of ABC Corp. we can see that while it had a positive net income of $23,000, its operating activities provided a negative $2,000 of cash flow. This should cause us some concern as we continue to work our through the rest of the statement.
At the bottom of the next section, we see that ABC’s investing activities also resulted in a negative cash flow, in this case the figure is $6,500. And in the last section we finally see some positive cash flow, to the tune of $3,500, as a result of ABC’s financing activities. The end result of all of this is that ABC saw its cash balance decline by $5,000 during the course of the year.
So what are we to make of all of this? ABC’s operating activities drained it of $2,500 in cash yet it spent $8,500 on new fixed assets (a long-term investment), and it covered part of these costs by increasing its debt load (the $3,500 in additional notes payable).
The situation at ABC is clearly not sustainable and this is reflected in the fact that its cash balance at the end of year declined by 42% ($5,000/$12,000). If ABC keeps on this same path for too much longer, it will eventually run out of cash. In order to remedy the situation, ABC needs to take a hard look at refining its core operating activities, in addition to determining whether it has the right mix of assets to support its business, and whether or not its debt load is sustainable. And of course, if you start to see your company’s cash position weakening, it is time to think about all of these things before the situation gets too dire.
So that concludes our series on the major financial statements that most firms produce, and that most lenders and investors want to see. We once again remind readers that this series is intended as an introduction to financial statements and a beginning look at their analysis. We hope that you are now better armed to analyze and make decisions about your firms’ financial matters, and encourage you to read further on these topics in a financial management textbook.