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Cash Is King
The importance of cash flow to the short term credit grantor is based on a simple fact, trade obligations are
satisfied with cash not profit. It is possible for a firm to be very profitable and not be able to service its obligations.
Short-term liquidity can also be achieved by deferring payments of current obligations, however, eventually the
company's ability to generate cash flow through the deferral of payment of current liabilities will be exhausted. This
statement is useful for decision making because it provides relevant and reliable information for predicting cash
flows.
The cash flow statement is an important analytical tool that the trade creditor can use to determine if a customer is
able to generate sufficient cash to meet its trade obligations. The ability of a company to adapt during a period of
financial adversity, to obtain financing, and generate adequate amounts of cash for specific purposes are very
important factors in the review process. Using the cash flow statement in the credit analysis process can help users
evaluate a customer's solvency, liquidity position, and its financial flexibility.
Operating activities
The statement provides information about the cash generated from a company's primary operating activities.
Operating activities relate to a company's primary revenue-generating activities, and cash flows from operating
activities are the cash effects of transactions and economic events included in the determination of income.
Operating activities that generate cash inflows include customer collections from sales of their primary products or
services, receipts of interest and dividends and other operating cash receipts. Operating activities that create cash
outflows include payments to suppliers, payments to employees, interest payments, payment of income taxes and
other operating cash payments.
Investing activities
Investing activities include lending money and collecting on those loans, buying and selling productive assets that
are expected to generate revenues over long periods, and buying and selling securities not classified as cash
equivalents. Cash inflows generated by investing activities include sales of long-lived assets such as property, plant,
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and equipment, sales of debt or equity instruments and the collection of loans.
Financing activities
Financing activities include borrowing and repaying money from creditors, obtaining resources from owners and
providing both a return on their investment and a return of their investment. The return on investment is provided in
the form of dividends.
The statement of cash flows provides information about how the company invests its cash on equipment and other
long term investments, and the cash provided if it disposes of fixed assets. If the firm uses debt or equity to expand
its operations, it is disclosed in the financing activities. Also, if the firm uses cash to retire debt, it appears in the
statement.
Exhibit 1
Star Light Corporation
Income Statement
For the year ended
December 31, 1999
Sales
Cost of Goods Sold
Gross Profit
Salaries Expense
Depreciation and Amortization
$250,000
120,000
130,000
40,000
25,000
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Operating Profit
65,000
Other Income (Expense)
Gain on the Sale of Equipment 10,000
Interest Expense
(10,000)
Net Income
$65,000
A practical approach for preparing the statement of cash flows is to first determine the net increase in cash and cash
equivalents for the period. This amount serves as a control figure, the net cash inflow or outflow must agree with
the net change in the cash account on the comparative balance sheets. For illustrative purposes, we will use the
Income Statement data from the current year (Exhibit 1) and the balance sheets from the prior two years that have
been combined on the Cash Flow Worksheet (Exhibit 2) of Star Light Corporation. To complete our first step we
begin with the balance sheet data, by taking the cash balance of $90,000 from the most recent balance sheet and
subtracting the cash balance of $50,000 from the prior year, which results in an increase in cash of $40,000. The
cash flow statement must balance to this control number.
Exhibit 2
Star Light Corporation
Cash Flow Worksheet
Comparative Balance Sheets Assets
1998
1999
Account
Balance
Change
Cash
Inflow /
Outflow
Activity
Type
Assets
Cash
Accounts Receivable
$50,000
Cash
70,000
60,000 (10,000)
Inflow
Operating
Inventories
100,000
75,000 (25,000)
Inflow
Operating
200,000
190,000 (10,000)
Inflow
Investing
Accumulated Depreciation
(40,000) (35,000)
5,000
Outflow
Operating
8,000
Outflow
Investing
Land
30,000
38,000
410,000
418,000
Accounts Payable
70,000
80,000
10,000
Inflow
Operating
Salaries Payable
10,000
15,000
5,000
Inflow
Operating
100,000
100,000
10,000
8,000
Common Stock
Total Assets
Liabilities and
Stockholders' Equity
Bonds Payable
0 No Change
Financing
(2,000)
Outflow
Financing
80,000
60,000 (20,000)
Outflow
Financing
40,000
30,000 (10,000)
Outflow
Financing
Inflow
* Operating Financing
100,000
125,000
25,000
$410,000 $418,000
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Next we calculate the change in each balance sheet account, determine if the change is a cash inflow or outflow, and
the activity that the account should be included in. The change in account balances is reflected in the Account
Balance Change column (Exhibit 2) of our worksheet. It is calculated by subtracting the prior year account balance
from the current year balance. For example, Accounts Receivable in 1996 was $60,000 compared to $70,000 in
1995, which resulted in a $10,000 decrease in receivables. This process is continued for each of the balance sheet
accounts.
After calculating the account balance change, we have to determine if the balance change is an inflow or an outflow
of cash. To make this task simple we can use Table I as a guide to determine the effect of each balance change. The
table states that a decrease in an asset balance and an increase in a liability or equity account are cash inflows. The
opposite holds true for increases in an asset balance or a decrease in a liability or equity account, which results in a
cash outflow.
Table I
Cash Effects of Balance Sheet Account Changes
Cash Inflow
Cash Outflow
Table II
Cash Flows by Activities
Operating Activities
Inflows of
Cash
Investing Activities
Financing Activities
Collection on Loans
Interest Income
Dividends Receipts
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Payment of Dividends
Payments to Employees
Acquisition of an Entity's
Own Equity Securities
Interest Payments
Making Loans
Table III
Cash Flows from Operating Activities using the Direct Method
Cash Collections from
Customers
Cash Payments to
Suppliers
Cost of Goods Sold + increase ( - decrease) in Inventory increase ( + decrease) in Accounts Payable
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Tax Expense - increase (+ decrease) in Accrued Taxes Payable decrease ( + increase) in Prepaid Tax
Based on the formulas provided in Table III, Star Light has the following cash flows from its Operating Activities:
Cash Collections from Customers = $250,000 + 10,000 = $260,000
Cash Payments to Suppliers = $120,000 - 25,000 - 10,000 = $85,000
Cash Payments for Salaries = $40,000 - 5,000 = $35,000
Cash Payments for Interest = $10,000 + 2,000 = $12,000 *
* Interest expense for the period equals interest paid during the period plus the decrease in Premium on Bonds Payable
By combining the above cash transactions into statement form, we complete the Operating Activities section of the
statement using the Direct Method. (Exhibit 3)
Exhibit 3
Star Light Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999
Cash Flows from Operating Activities (Direct Method)
Cash collections from Customers
$260,000
(85,000)
(35,000)
(12,000)
Table IV
Cash Flows from Operating Activities using the Indirect Method
Net Income
Adjustments to reconcile net income to net
cash provided by operating activities
+ Depreciation
- Amortization of Bond Premium
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Table V
Cash Effects of Income Statement Account Changes
Cash Inflow
Cash Outflow
Revenue Accounts are Sources of Cash Expense Accounts are Uses of Cash
Based on the formula provided in Table IV, we are able to reconcile Star Light's net income with net cash provided
by its Operating Activities. (Exhibit 4)
Exhibit 4
Star Light Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999
$65,000
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Decrease in Inventories
10,000
5,000
$128,000
A comparison of the Direct Method with the Indirect Method indicates that either method will generate the same
results. The Operating Activities of Star Light Corporation generated $128,000 in net cash during 1996.
Sales
= Ending Equipment
+ $40,000 - $50,000 =
$190,000
From a review of the Cash Flow Worksheet (Exhibit 2) we can infer that land was purchased for $8,000 cash. By
combining these three transactions we can develop the investing section of the cash flow statement.
Exhibit 5
Star Light Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999
Cash Flows from Investing Activities
Sale of Equipment
$30,000
Purchase of Equipment
($40,000)
Purchase of Land
($8,000)
Net Cash Used by Investing Activities ($18,000)
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from owners and providing them with both a return of their investment and a return on their investment in the form
of dividends.
A review of the Cash Flow Worksheet (Exhibit 2) indicates that there was a reduction in the common stock account.
After an investigation it is determined that Star Light Corporation retired common stock with a book value of
$30,000 for $35,000. On the statement of cash flows, this financing transaction would be reported as the retirement
of common stock requiring $35,000 in cash. This transaction would have also reduced retained earnings by $5,000.
Cash dividends for 1996 totaled $35,000. This financing transaction also reduced cash. By combining these two
transactions we can develop the financing section of the cash flow statement. (Exhibit 6)
Exhibit 6
Star Light Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999
Cash Flows from Financing Activities
Retirement of Common Stock
($35,000)
Payment of Dividends
($35,000)
($70,000)
Exhibit 7
Star Light Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999
Cash Flows from Operating Activities
Cash collections from Customers
$260,000
(85,000)
(35,000)
(12,000)
$128,000
$30,000
Purchase of Equipment
(40,000)
Purchase of Land
(8,000)
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10
(18,000)
($35,000)
(35,000)
(70,000)
$40,000
50,000
$90,000
Conclusion
The primary purpose of the cash flow statement is to provide information about a company's cash inflows and
outflows. A secondary purpose is to provide information about the investing and financing activities of the
company. The Star Light Corporation provided an excellent illustration of the basic concepts and procedures
required to prepare a statement of cash flows. Information reported in the statement, when used with other financial
statements provides the analyst with insights about the company's ability to generate future cash flows. It helps the
user understand the differences between a company's income flows and cash flows. The information provided by
the cash flow statement will also help you assess a company's ability to pay its debts and to meet its external
financing needs.
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11
So, how does a business finance growth? There are only two basic sources of financing -- externally generated
funds and internally generated funds. External sources are the ones we all think of when it's time to raise money and
include more investment from the present ownership, bringing others in as investors, borrowings in the form of
loans, or by increasing your obligations to vendors (accounts payable).
The only true long term internal source of funds is profits. The business manager must be constantly vigilant in
maintaining profit margins by watching both pricing and purchasing. However, most businesses are not able to
make as high a percentage profit as would be needed to provide all the funds necessary for rapid growth. So, growth
must occur at a controlled rate or the management must find more external capital. If profits are not constantly
generated, the implications for business longevity are pretty clear. We have seen several mature businesses who
complained of "being undercapitalized and if they could just get a loan" or come up with an investor, they "would
be all right". After digging a bit deeper, we often find that a more than adequate amount of capital has been invested
but the company has not been generating profits for such a long time that they are, in effect, consuming their capital
in supporting the present operations. As an excuse for business difficulty or failure, "undercapitalization" ranks right
up there with "poor management" as being one of those catch-all terms which is often used when one is unsure
what's wrong.
As the investment in machinery, equipment, and inventory rise, so, too must the amount of permanent capital
generated by or invested in the business rise. Even with seasonal or cyclical fluctuations, a growing business
generally has growing demands for permanent capital. There is an old rule of business finance that advocates
matching the length of financing of an asset to the useful life of that asset. It is very dangerous to attempt to finance
long term capital needs with short term capital sources. The manager who uses a short term loan or, worse yet, line
of credit, to finance permanent increases in inventory or the purchase of equipment, is virtually guaranteeing a
future cash crisis. Short term sources of financing should be used only for the purchase of short terms assets like
that portion of inventory that is truly seasonal and will, therefore, be sold during the term of the financing.
This publication was produced by the Delaware Small Business Development Center Network and can be found on
their web site: http://www.be.udel.edu/sbdc. The Center can be contacted at: 102 MBNA America Hall, University
of Delaware, Newark, DE 19716. Phone: (302) 831-1555; Fax: (302) 831-1423
Copyright 1999 Credit Research Foundation
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