Key Concepts in Accounting: Statement of Cash Flows

These flashcards cover key concepts related to accounting and the statement of cash flows, including terms related to accrual accounting, cash flow, and various financial statements.

Statement of Cash Flows

A financial statement that shows net cash flow associated with operating, investing, and financing activities.

How is profitability measured

with accrual accounting (it also creates differences between profitability and cash flow)

Accrual Accounting

An accounting method where revenues and expenses are recorded when they are earned or incurred, not when cash is actually received or paid.

–Not all costs are reported as expenses

•Expenses are only those costs associated with revenue

Three Main Reasons Why Profit Does Not Equal Cash Flow

Profit does not equal cash flow because revenue is recognized when earned, not when cash is received, and expenses may be recorded at different times. Capital expenditures also don’t count against profit

Revenue Recognition

The accounting principle that dictates when revenue should be recognized, typically when a product or service is delivered.

Capital Expenditures

Expenses incurred for acquiring or upgrading physical assets such as property, plant, and equipment, which are not reported immediately on the income statement.

the amount you pay for an asset or an input for your business (e.g. inventory)

Cost

•the portion of a cost that is recorded in the income statement

expense

What causes timing differences in costs and expenses?

Timing differences occur because of accrual accounting, where costs and expenses can be recorded in different time periods.

Why do some costs get paid before the expense is reported?

Some costs, like inventory buildup, are paid for before the expense is reported. The expense is recorded later when the inventory is sold.

Why do some costs get paid after the expense is reported?

Some costs, like supplies bought on credit, are paid for after the expense is reported. The expense is recorded earlier when the supplies are acquired.

What is the impact of timing differences on cash flow and expenses?

Timing differences create a mismatch between cash flow and expenses, leading to differences in reported earnings and actual cash payments.

What does matching COGS to revenue mean?

It means that the Cost of Goods Sold (COGS) is recorded as an expense only when the related revenue is earned, ensuring expenses align with sales.

Cost of Goods Sold (COGS)

An expense that represents the cost of producing or purchasing the goods sold by a business, recorded only when the inventory is sold.

Depreciation

The process of allocating the cost of a tangible asset over its useful life, impacting both cash flow and profit.

Depreciation and amortization expenses are non-cash expenses

Unpaid Expenses

Costs that a business records as expenses but has not yet paid, such as accounts payable and accrued expenses.

Unpaid expenses are costs recorded as expenses before they are actually paid, creating liabilities on the balance sheet.

What is accounts payable?

Accounts payable includes unpaid bills for items like supplies bought on credit, legal work, and utilities.

What are accrued expenses payable?

Accrued expenses payable are estimated costs a business owes but has not yet paid, such as unused vacation, unpaid bonuses, or accumulated interest.

How does income tax payable work?

A business may not pay 100% of its owed income tax to the IRS by year-end, creating an income tax payable liability.

Cash Flow from Operations

Cash generated from normal business operations, typically from selling products and services and paying for expenses.

What are the three main components of the Statement of Cash Flows?

1. Cash flow from operations
2. Cash flow from investing activities
3. Cash flow from financing activities

What are the cause of changes in Cash

1.Normal business operations

–Cash from the net result of selling products or services and paying for expenses

2.Buying and selling long term assets

–For example, buying or selling machines

–Buying or selling long term investment securities

3.Raising money or paying back money

–Sale of common or preferred stock

–Borrow money (or repay a loan)

–Pay dividends

Balance Sheet

A financial statement that summarizes a company's assets, liabilities, and shareholders' equity at a specific point in time, providing insight into its financial position.

What is the relationship between assets, liabilities, and cash flow?

• Assets and cash move oppositely: When assets go up, cash goes down, and vice versa.

• Liabilities and cash move together: When liabilities go up, cash increases, and when liabilities go down, cash decreases.

How do balance sheet changes affect cash flow?

• Asset increases → Consumes cash (e.g., buying equipment).

• Asset decreases → Provides cash (e.g., selling inventory).

• Liability increases → Provides cash (e.g., taking a loan).

• Liability decreases → Consumes cash (e.g., repaying debt).

Why is cash flow just as important as profitability for businesses?
Back:

• A business can appear profitable but fail due to insufficient cash flow.

• A business can have strong cash flow, which may hide a lack of profitability.

• Both profitability and cash flow must be managed to ensure long-term success.

Why is managing both profitability and cash flow especially crucial for small, growing businesses?

Small, growing businesses need to balance profitability and cash flow because a strong profit does not guarantee sufficient cash, and poor cash flow can prevent even profitable businesses from sustaining operations.

Why look at Cash Flow

•Tells you whether business operations are healthy

•Shows you what you can better manage

–Accounts receivable, inventory, etc.

•Make better decisions

What are the two ways to measure cash flow

precise way and approximate way

What is the precise way

•:  directly measure cash inflows and outflows

–Typically monthly

What is the approximate way

estimate cash flow by using financial statements (liike EBITDA)

Steps in Direct Measurement of Cash Flow

•Perform monthly

•Add up all cash receipts

–Both cash payments for products and payments from accounts receivables

•Add up all cash expenditures

–Payment for salaries, supplies, inventory, etc.

–Purchase of capital equipment (machines, etc.)

Reconcile receipts and expenditures with beginning and ending cash balance in your bank account

•Current or potential investors or lenders use cash flow estimates to:

–Assess the venture’s financial health

–Assess future financing needs

–Estimate the value of the venture

Two common estimates of cash flow based on financial statements:

EBITDA

Free Cash Flow to Equity (FCFE)

EBITDA stands for

Earnings Before Interest, Taxes, Depreciation, and Amortization

Formula:  Net Income (i.e. earnings)

  +   Interest

  +  Taxes

  +  Depreciation

  +  Amortization

  =   EBITDA

Two Uses of EBITDA

–EBITDA estimates cash flow before interest payments, so it is a measure of ability to cover interest charges

•Investors use EBITDA as a basis for estimating the value of a venture

•EBITDA is an estimate of cash flow

WHAT DOES BAD AND GOOD EBITDA MEAN

–“Bad”:  EBITDA ignores big changes in accounts receivable and inventory, among other items

–“Good”:  EBITDA “smooths out” cash flow volatility due to working capital changes

Why is EBITDA likely to overstate cash flow for most startups?

Startups often experience a rapid buildup of accounts receivable, inventory, and other assets.

How can EBITDA overstate cash flow in relation to debt and capital expenditures?

EBITDA can overstate cash if a company repays debt or buys equipment, machines, or buildings (capital expenditures).

What is the formula for working capital?

Working capital = current assets of a business.

What makes an asset "current"?

An asset is considered current if it is cash or expected to convert into cash within one year.

What are current assets?

Current assets are liquid assets that can be easily converted into cash.

What does "liquid" refer to in the context of assets?

"Liquid" refers to an item that is cash-like or can easily be converted into cash.

•Common items in Working Capital:

–Cash

–Short Term Investments

–Accounts Receivable

–Inventory

•All of these items are either cash, or can be converted to cash within a short period of time

•Net working capital =

working capital (or current assets) – current liabilities

•Current liabilities =

accounts payable and other short term obligations

Formula for networking capital

Current assets

-Current liabilities

= Net working capital

•Therefore, in order to manage cash flow, you need to manage:

–Accounts receivable

–Accounts payable

Inventory

What happens when you allow customers to pay late?

By allowing customers to pay late, you are giving them an interest-free loan to cover their own costs.

How to Manage Accounts Receivable Aggressively

•Know how your customers pay their bills and time your invoices carefully

•Know the name of the person at your customer who pays the bills

–The “accounts payable clerk”

•Don’t be afraid to call and ask for payment.  But …have the CFO do it, not the owner or CEO

What types of customers may cause slow payments in certain industries?

Slow payers like government or health insurance companies.

What should customers complete before you provide services or products?.

A credit report

What should you do with a prospective customer's references?

Contact references to inquire about their credit experience.

What can you do if a customer has no or bad credit history?

Set specific payment terms or require upfront payments.

What should customers complete before you provide services or products?

a credit report

Options For Customers with No or Bad Credit History

•At time of order, require an upfront payment equal to COGS for the order, with balance due at shipment

•Obtain 100% payment before work on the order can begin

•Require a 100% payment before or at time of delivery (“cash on delivery” or “COD”)

•Request 33% payment at order receipt, another 33% at delivery, with balance due 30 days later

Managing Accounts Payable

•Negotiate better payment terms, such as net 45 or net 60, instead of net 30

•Time payments according to their due dates, such as 30 days after receipt of the product, rather than immediately upon receipt

•Plan your cash flow.  For example, some companies pay payroll every two weeks, and pay other bills during the other two weeks of the month.

•Communicate with your suppliers and establish a good relationship – if you almost always pay on time, you may be granted one month to pay late without penalty

•Provide supervision from the top

–Pay attention if your business has chronically low cash balances; it is a warning sign

Managing Working Capital

•Managing working capital effectively can increase the cash flow in your business

•… the more cash you have in your business, the less cash you need to raise from outside investors

•…the less cash you raise from outside investors, the greater your ownership stake in your firm

•Ratios

indicate the relationship of one number to another

What are the different purposes of Financial Ratios

–Bankers and lenders look at ratios such as the current ratio and debt-to-equity to assess a company’s ability to pay back a loan

–Entrepreneurs look at gross margins to monitor profitability

–Investors look at multiples, such as EBITDA multiples, as part of assessing valuations

What are benefits of ratios

•Provide a point of comparison (e.g. profit compared to sales)

•Ratios can be compared over time to provide a trend analysis

•Ratios can be compared to competitors and industry averages (benchmarking)

What are the type of Ratios

•Profitability ratios

•Leverage ratios

•Liquidity ratios

•Efficiency ratios

What are some important profitability ratios

–Gross profit margin percentage

–Operating profit margin percentage

–Net profit margin percentage

–Return on assets (ROA)

–Return on equity (ROE)

•Return on assets (ROA) =

net profit / average total assets

•ROA shows what percentage of every dollar invested in the business is returned to you as profit

•Return on equity (ROE) =

net profit / average shareholders’ equity

•ROE shows an implied rate of return for shareholders

•ROE is often a target that helps determine the bonus of senior executives

•Public companies with relatively high ROE’s tend to have above-average share price appreciation

Leverage Ratios

•show the degree to which a company has borrowed money to finance (or fund) its asset base

•Also called “financial leverage”

•High leverage ratios suggest

higher risk, because the the interest payments associated with debt represent an expense burden

•Debt-to-equity ratio

= total liabilities / shareholders’ equity

•What is considered “good” varies by industry

•If bankers consider a debt-to-equity ratio to be too high, they may reject a request for a loan

What is one measure of interest coverage?

EBITDA / annual interest charges.

What does an interest coverage ratio of 1.0 mean?

The company can just make interest payments.

Liquidity Ratios

measure the ability of a company to meet its short term obligations

•Current ratio = current assets / current liabilities

A current ratio of 2.0 is considered good

•Quick ratio

= (current assets – inventory) / current liabilities

•Therefore, the quick ratio is the current ratio with inventory removed, so it is more conservative

•Quick ratio is especially appropriate if the business has a lot of cash tied up in inventory

•The quick ratio should be above 1.0

•Efficiency ratios

measure how effectively a company manages its assets

•Types of efficiency ratios include “turnover” ratios and “days outstanding” ratios

•Days in inventory (DII) is also called

“inventory days”

•DII measures the number of days inventory stays in the system

•DII = average inventory / (COGS / day)

•Inventory turns converts DII to number of times inventory turns over per year

•Inventory turns = 365 / DII

•Days Sales Outstanding,

or DSO, is also known as average collection period or receivable days

•Measure of average time it takes to collect the cash from sales; i.e. how fast customers pay their bills

•DSO = ending accounts receivable / revenue per day

Days Payable Outstanding

•The mirror image to DSO

•Days Payable Outstanding (DPO) =  ending accounts payable / COGS per day

•The higher a company’s DPO, the better the company’s cash position, but the less happy are its vendors

•DPO serves as a reflection of a company’s payment policies

Cash Conversion Cycle

•Basic business fact:

–First you pay for supplies and inventory

–Then, your customers pay you

•Period between payment of cash and receipt of cash = cash conversion cycle, or cash gap

•Cash gap = inventory days + days receivables – days payable

Three Ways to Shorten the Cash Conversion Cycle

–Increase inventory turnover

–Decrease the number of days it takes to collect receivables

–Increase the number of days it takes to pay for inventory

What do short cash gaps reflect

the efficient use of cash, which reduces the need to raise money from outside investors

(the shorter the cash gap, the better)

Asset Turnover

is a measure of how efficiently a business uses its assets to generate revenue

What is the formula for asset turnover and what do low turnovers suggest?

•Revenue / Average Total Assets

•Low turnover ratios may suggest that a business has too much inventory, too many accounts receivable, or inefficient equipment and factories