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101: Statement of Cash Flows Part II
By Gregg Schoenberg Wednesday, February 1, 2012

ABC Corp. Statement of Cash Flows for 2010

  Cash Provided or Used
Operating Activities                      
Net Income $23,000
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)
Investing Activities  
   Cash Used to Acquire Fixed Assets ($8,500)
   Sale of Short-Term Investments $2,000
Net Cash Provided by Investing Activities ($6,500)
Financing Activities  
   Increase in notes payable $3,500
Net Cash Provided by Financing Activities $3,500
Summary  
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.

 

 

 

 

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101: Statement of Cash Flows Part I
By Gregg Schoenberg Tuesday, January 31, 2012

Now that we have completed our guides to understanding your company’s balance sheet (Part I and Part II) and income statement (Part I and Part II), it is time to turn our attention to the third and final of the major financial statements, the statement of cash flows.  Like the income statement, the statement of cash flows gives us a picture of a company’s performance for a period of time, usually a calendar year or quarter.  But while the income statement is concerned with tracking net income, the statement of cash flows, as the name implies, is concerned with reporting changes in a firm’s cash position.  As we take a look at our sample statement of cash flows and decipher its entries, we will see that a company’s net income is very different from its cash position.

 

ABC Corp. Statement of Cash Flows for 2010

  Cash Provided or Used
Operating Activities                      
Net Income $23,000
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)
Investing Activities  
   Cash Used to Acquire Fixed Assets ($8,500)
   Sale of Short-Term Investments $2,000
Net Cash Provided by Investing Activities ($6,500)
Financing Activities  
   Increase in notes payable $3,500
Net Cash Provided by Financing Activities $3,500
Summary  
Net Change in Cash ($5,000)
Cash at Beginning of Year $12,000
Cash at End of Year $7,000

 

 

As we can note from the above sample of our fictitious ABC Corporation, the statement of cash flows is broken down into three categories—operating activities, investing activities, and financing activities—plus a summary section at the bottom.  If you are now familiar with the balance sheet and income statement from our previous posts, you should recognize most of the line items here because what the statement of cash flows does is pull information from those two statements in order to analyze their effects on ABC’s cash position.  As we go through the entries below, you may want to refer back to  ABC’s balance sheet and income statement to see where the numbers are coming from.

Net Income – Is the “bottom line” figure from the income statement.

Increases in Accounts Receivable, Inventories, Accounts Payable, and Accrued Payroll – These are all calculated by taking the difference between these figures on two successive balance sheets (e.g. 2010 and 2009 year-end).  For simplicity’s sake we only provided one year’s balance sheet for ABC Corp., but once your business has produced two or more balance sheets you would simply use the two most recent ones in order to make these calculations.  One important thing to note here is that an increase in a current asset decreases cash while an increase in a current liability increases cash.  For example, if your inventory (a current asset) increased, your cash would have to decrease by a like amount to pay for that inventory.

Cash Used to Acquire Fixed Assets – Calculated by taking the difference between the “Fixed Assets” entries on the two most recent balance sheets.

Sale of Short-Term Investments – Reflects short-term investments that have been converted to cash.

Increase in Notes Payable – Indicates the amount of additional short-term debt ABC has taken on.

Net Change in Cash – Equals the sum of the net cash provided by operating, investing, and financing activities.

Cash at Beginning of Year – Equals the Cash figure at the top of the most recent balance sheet.

Cash at End of Year – Cash at beginning of year minus the net change in cash.

Next, we will teach you how to analyze the statement of cash flows and show you why one item on it just might be the single most important figure to look at when analyzing any company.

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A New Space for the New Year
By Gregg Schoenberg Wednesday, January 25, 2012

When the time comes to remodel your business’s office space, or to move into a new space, it is easy to think of the process solely in terms of cost.  After all, no matter how nice a conference table or how attractive a desk you purchase, it is hard to imagine them adding anything to your bottom line.  But by taking a holistic, rather than a piecemeal, approach to remodeling, and viewing your office as an asset that can yield returns in terms of efficiency, productivity, and employee performance, you can realize long-term cost savings and benefits from a well-planned office from the ground up.

If you are considering an office remodel then you’ll want to focus on maximizing the utility of the following features in order to get the best return on your investment.

Walls

Once you’ve owned your own business for some time—and been through the ups and downs of a few economic cycles—you come to realize that it’s not just the amount of space you need that can change, but also the way in which that space is configured.  Moveable walls are a great solution that can save you a substantial amount of money compared to fixed walls, while also offering the flexibility to change the layout of specific spaces (e.g. from a set of private offices to a conference room) virtually overnight.  Moveable walls come in a variety of durable materials and finishes including some that incorporate glass, allowing natural light to flow further into a large work setting.

Light

Increasing the amount of natural light that enters your workspace has myriad benefits.  In addition to being aesthetically preferable to artificial alternatives, natural light will reduce your energy bills and has been shown to boost worker productivity.  Besides designing your office to take full advantage of available natural light, installing a lighting system that works in conjunction with natural light by dimming or shutting off entirely when there is ample natural light can save you additional money on utility bills.

Floors

With an office remodel it’s not so much the floors as what’s underneath them that can add the most value. By taking advantage of raised-access technology it is possible to house the majority of your power, data, and communications cables underneath the floors and out of sight.  On top of the obvious aesthetic benefit, the under-floor setup provides outstanding flexibility for the inevitable future configuration changes and furniture reshuffling.  If you are doing a major remodel, or starting fresh in a new space, it is also worth looking into an under-floor HVAC (heating, ventilation, and air conditioning) system, which can offer increased energy efficiency, improved air quality, and a safer alternative to traditional wall-mounted systems.

Furniture

Outfitting your remodeled space with new furniture should be the last step in the remodel.  Hopefully you’ll have taken into account the advice to create a flexible workspace when choosing walls and floors, so you’ll want to select furniture that is flexible as well. There are lots of choices in both modular office furniture and adaptable workstations that can help keep you from having to purchase new items every time your needs change.

By carefully planning your remodel with an eye toward increased efficiency as well as future organizational change, you should be able to recoup some of the cost of the remodel and wind up with an office that allows your firm to adapt to whatever changes lie ahead.

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Phishing Email Trap using the Better Business Bureau
By Brett Melson Tuesday, January 24, 2012

Reputable businesses, including Harvard Business Services, are proud of their well-earned ranking of A+ with the Better Business Bureau.  If and when they receive an email involving what appears to be a complaint about their practices from the BBB, it would seem to make sense to open it and see what the problem could be.  That is when the trouble can really begin.  If the affected link or attachment is opened, malware is launched which can quickly wreak havoc and steal information from your computer.

It is easy to be fooled, because most of these bogus emails carry the famous BBB torch logo, and come with a subject line such as “Complaint from your customers.”  Below is an example of one of the phishing emails Harvard Business Services recently received:

 

From: BBB Subject: BBB processing RE: Case ID 43616056

Attention: Owner/Manager

Here with the Better Business Bureau would like to notify you that we have been filed a complaint (ID 43616056) from your customer in regard to their dealership with you.

Please open the Complaint report below to view the details on this matter and let us know of your position as soon as possible.

We are looking forward to hearing from you.

Faithfully,

Gerard Johnson

Dispute Counselor?Better Business Bureau

 

As you can see, it would be easy for an unsuspecting business, concerned about keeping a high ranking with the BBB to open this.

The BBB recommends to anyone receiving such email:

  • Do not open any attachments
  • Do not click on any links
  • Delete the email from your inbox, and then delete it again from your trash or recycling folder

The Better Business Bureau was founded in 1912 and is a private, nonprofit organization that provides programs of assistance to businesses and consumers.  Their focus is to promote ethical business practices by encouraging honest advertising and selling practices.  They also can serve as a neutral third party to settle marketplace disputes.  Their role in helping to resolve a buyer/seller complaint against a company is very helpful in many cases, and encourages corrections and improvements where appropriate. As the BBB states, “Our mission is to promote and foster the highest ethical relationship between businesses and the public through voluntary self-regulation, consumer and business education, and service excellence.”

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101: Income Statement Part II
By Gregg Schoenberg Monday, January 23, 2012

ABC Corp. Income Statement Dec. 31, 2010

Total Revenue $150,000
Cost of Goods Sold (COGS) $60,000
Gross Profit  $90,000
Operating Expenses  
Research & Development (R&D) $5,000
Selling, General and Administrative Expenses (SG&A) $45,000
 Operating Income    
Earnings Before Interest & Taxes (EBIT) $40,000
Interest Expense $5,000
Taxes (30%) $12,000
Net Income $23,000

 

In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 - $5,000 - $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.

 

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