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As we saw in chapter 13, there can be a difference between net income and cash flow. We were given 3 main reasons for this…

1) Depreciation, which as we know is an expense the business takes to write down that periods cost of using an asset. Since this is NOT a cash transaction, we have to add back this expense in the cash flow statement.

2) Operating assets (accounts receivable, inventory and prepaid expenses) affect cash flow from profit. Unlike depreciation, the effects of operating assets can be positive or negative. For example, if receivables increase, this delays cash flows. If, however, receivables decrease this increases cash inflows.

3) Operating liabilities (accounts payable, accrued expenses and income tax payable) help cash flow during the year by avoiding making payments until a later date.

Next we will look at future cash flows (take a look at exhibit 16.1). The author assumes that everything for next year stays the same as last year. He then explains how to make the adjustments. He also talks about how extending payment terms can change cash flow projections. Note his term “Cash Cow”.

Cash Flow Growth Penalty

Growth is what, as investors, is what we want to see. Poor management can lead to expenses growing faster than revenue and profit may actually decrease. During hard times, holding steady may be the best a company can do.

Exhibit 16.2 is the CEO looking to see how revenue growth will impact the company’s cash flow. Note the “Budgeted Changes for Next Year”, all percentages are held the same from previous chapters. Sales revenue increases by $6,500, which caused Accounts Receivables to increase by $625 ( thus reducing cash flows). Looking at the bottom lines, we see that profit increased faster than cash flow, showing how it is possible for a profitable business to need to borrow money or in extreme cases, go bankrupt.

Exhibit 16.3 is showing the other side...a decline in revenues. Here a business is rewarded on the cash flow statement for declining revenues. While cash is king, this is not a good long-term place to be. Management needs to find a way to turn the business around.

Next week we begin to have a little fun with ratios and how to use them.
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