6.3. Dissecting the Difference Between Cash Flow and Net Income
|
The business in our example experienced a strong growth year. Its accounts receivable and inventory increased by relatively large amounts. In fact, all its assets and liabilities intimately connected with sales and expenses increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). Of course, this may not always be the case in a growth situation; one or more assets and liabilities could decrease during the year. For flat, no-growth situations, it's likely that there will be a mix of modest-sized increases and decreases.
The following sections explain how the asset and liability changes affect cash flow from operating activities. As a business manager, you should keep a close watch on the changes in each of your assets and liabilities and understand the cash flow effects caused by these changes. Investors should focus on the business's ability to generate a healthy cash flow from operating activities, so investors should be equally concerned about these changes. In some situations these changes can signal serious problems!
I realize that you may not be too interested in the details that I discuss in the following sections. With this in mind, at the start of each section I present the punch line. If you wish, you can just read this and move on. But the details are fascinating (well, at least to accountants).
Note: Instead of using the full phrase "cash flow from operating activities" every time, I use the shorter term "cash flow" in the following sections. All data for assets and liabilities are found in the two-year balance sheet of the business (see Figure 5-2).
6.3.1. Accounts receivable change
Punch Line: An increase in accounts receivable hurts cash flow; a decrease helps cash flow.
NOTE
The accounts receivable asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, accounts receivable is the amount of uncollected sales revenue at the end of the period. Cash does not increase until the business collects money from its customers.
The business started the year with $2.15 million and ended the year with $2.6 million in accounts receivable. The beginning balance was collected during the year, but the ending balance had not been collected at the end of the year. Thus the net effect is a shortfall in cash inflow of $450,000. The key point is that you need to keep an eye on the increase or decrease in accounts receivable from the beginning of the period to the end of the period. Here's what to look for:
If the amount of credit sales you made during the period is greater than what you collected from customers during the period, your accounts receivable increased over the period, and you need to subtract from net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, an increase in accounts receivable hurts cash flow by the amount of the increase.
If the amount you collected from customers during the period is greater than the credit sales you made during the period, your accounts receivable decreased over the period, and you need to add to net income that difference between start-of-period accounts receivable and end-of-period accounts receivable. In short, a decrease in accounts receivable helps cash flow by the amount of the decrease.
In our business example, accounts receivable increased $450,000. Cash collections from sales were $450,000 less than sales revenue. Ouch! The business increased its sales substantially over the last period, so you shouldn't be surprised that its accounts receivable increased. The higher sales revenue was good for profit but bad for cash flow.
NOTE
The "lagging behind" effect of cash flow is the price of growth — managers and investors need to understand this point. Increasing sales without increasing accounts receivable is a happy situation for cash flow, but in the real world you usually can't have one increase without the other.
6.3.2. Inventory change
Punch Line: An increase in inventory hurts cash flow; a decrease helps cash flow.
Inventory is usually the largest short-term, or current, asset of businesses that sell products. If the inventory account is greater at the end of the period than at the start of the period — because unit costs increased or because the quantity of products increased — the amount the business actually paid out in cash for inventory purchases (or for manufacturing products) is more than what the business recorded in the cost of goods sold expense for the period.
In our business example, inventory increased $725,000 from start-of-year to end-of-year. In other words, to support its higher sales levels in 2009, this business replaced the products that it sold during the year and increased its inventory by $725,000. The business had to come up with the cash to pay for this inventory increase. Basically, the business wrote checks amounting to $725,000 more than its cost of goods sold expense for the period. This step-up in its inventory level was necessary to support the higher sales level, which increased profit even though cash flow took a hit.
6.3.3. Prepaid expenses change
Punch Line: An increase in prepaid expenses (an asset account) hurts cash flow; a decrease helps cash flow.
A change in the prepaid expenses asset account works the same way as a change in inventory and accounts receivable, although changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.
The beginning balance of prepaid expenses is charged to expense this year, but the cash for this amount was actually paid out last year. This period (the year 2009 in our example), the business pays cash for next period's prepaid expenses, which affects this period's cash flow but doesn't affect net income until next period. In short, the $75,000 increase in prepaid expenses in this business example has a negative cash flow effect.
NOTE
As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in accounts receivable, inventory, and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.
6.3.4. The depreciation factor
Punch Line: Recording depreciation expense decreases the book value of long-term operating (fixed) assets. There is no cash outlay when recording depreciation expense. Each year the business converts part of the total cost invested in its fixed assets into cash. It recovers this amount through cash collections from sales. Thus, depreciation is a positive cash flow factor.
The amount of depreciation expense recorded in the period is a portion of the original cost of the business's fixed assets, most of which were bought and paid for years ago. (Chapters 4 and 5 explain more about depreciation.) Because the depreciation expense is not a cash outlay this period, the amount is added to net income to determine cash flow from operating activities (see Figure 6-2).
For measuring profit, depreciation is definitely an expense — no doubt about it. Buildings, machinery, equipment, tools, vehicles, computers, and office furniture are all on an irreversible journey to the junk heap (although buildings usually take a long time to get there). Fixed assets (except for land) have a limited, finite life of usefulness to a business; depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue.
|
For example, when you go to a supermarket, a very small slice of the price you pay for that quart of milk goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much!) Each period, a business recoups part of the cost invested in its fixed assets. In the example, $775,000 of sales revenue went toward reimbursing the business for the use of its fixed assets during the year. In short, depreciation is a positive cash flow factor. The depreciation amount is imbedded in sales revenue, and sales revenue generates cash flow.
NOTE
The business in our example does not own any intangible assets and, thus, does not record any amortization expense. (See Chapter 5 for an explanation of intangible assets and amortization.) If a business does own intangible assets, the amortization expense on these assets for the year is treated the same as depreciation is treated in the statement of cash flows. In other words, the recording of amortization expense does not require cash outlay in the year being charged with the expense. The cash outlay occurred in prior periods when the business invested in intangible assets.
6.3.5. Changes in operating liabilities
Punch Line: An increase in a short-term operating liability helps cash flow; a decrease hurts cash flow.
The business in our example, like almost all businesses, has three basic liabilities inextricably intertwined with its expenses:
Accounts payable
Accrued expenses payable
Income tax payable
When the beginning balance of one of these liability accounts is the same as its ending balance (not too likely, of course), the business breaks even on cash flow for that account. When the end-of-period balance is higher than the start-of-period balance, the business did not pay out as much money as was recorded as an expense in the year.
In our business example, the business disbursed $640,000 to pay off last year's accounts payable balance. (This $640,000 was the accounts payable balance at December 31, 2008, the end of the previous fiscal year.) Its cash this year decreased $640,000 because of these payments. But this year's ending balance sheet (at December 31, 2009) shows accounts payable of $765,000 that the business will not pay until the following year. This $765,000 amount was recorded to expense in the year 2009. So, the amount of expense was $125,000 more than the cash outlay for the year; or, in reverse, the cash outlay was $125,000 less than the expense. An increase in accounts payable benefits cash flow for the year. In other words, an increase in accounts payable has a positive cash flow effect. Increases in accrued expenses payable and income tax payable work the same way.
NOTE
In short, liability increases are favorable to cash flow — in a sense, the business ran up more on credit than it paid off. Such an increase means that the business delayed paying cash for certain things until next year. So you need to add the increases in the three liabilities to net income to determine cash flow, as you see in the statement of cash flows (refer to Figure 6-2). The business avoided cash outlays to the extent of the increases in these three liabilities. In some cases, of course, the ending balance of an operating liability may be lower than its beginning balance, which means that the business paid out more cash than the corresponding expenses for the period. In this case, the decrease is a negative cash flow factor.
6.3.6. Putting the cash flow pieces together
|
Taking into account all the adjustments to net income, the bottom line (oops, I shouldn't use that term when referring to cash flow) is that the company's cash balance increased $1,515,000 from its operating activities during the year. The first section in the statement of cash flows (refer to Figure 6-2) shows the stepping stones from net income to the amount of cash flow from operating activities.
What do the figures in the first section of the cash flow statement (refer to Figure 6-2) reveal about this business over the past period? Recall that the business experienced sales growth during this period. The downside of sales growth is that assets and liabilities also grow — the business needs more inventory at the higher sales level and also has higher accounts receivable. The business's prepaid expenses and liabilities also increased, although not nearly as much as accounts receivable and inventory.
The growth of the business in 2009 over 2008 yielded higher profit but also caused a surge in its assets and liabilities — the result being that cash flow is $175,000 less than its net income. Still, the business had $1,515,000 cash at its disposal. What did the business do with this $1,515,000 of available cash? You have to look to the remainder of the cash flow statement to answer this very important question.