Same scenario, change of assumptions:
The following are the changes in assumptions:
1) You will not repay either yourself or the bank in the first year, both debts are classified as long term on your balance sheet, as they do not require repayment within 12 months
2) Your receivables at year end will be $2 million on account of unsold inventory at client locations
3) Your inventory at year end will be $2 million
4) You will owe your suppliers $1.8 million at year end
5) The cash at year end will be $0.5 million
First let’s have a look at what you balance sheet will look like:
Current assets:
Cash $0.5 million
Accounts receivable $2 million
Inventory $2 million
Total current assets $4.5 million
Equipment $1.5 million
Total assets $ 6 million
Current liabilities:
Accounts payable $1.8 million
Long term liabilities:
Due to bank $1 million
Due to shareholder $1 million
Total liabilities $3.8 million
Retained earnings $2.2 million
Total liabilities & RE $6 million
Is this situation better or worst than the scenario provided in the previous post?
Let’s again examine the situation from a balance sheet and income statement perspective alone first. At fist glance the balance sheet appears strong. There is $0.5 million of cash (that’s a $1 million improvement from the first scenario), the total assets are now worth $6 million as opposed to $1 million, and the current ratio is 2.5 (4.5/1.8). Generally companies try to maintain a current ration above 1 (ratios will be covered in future posts). Therefore, the balance sheet appears strong.
Similarly, the income statement suggests the same, with earnings of $2.2 million in your first year.
If all is as strong as it appears than the statement of cashflow should reflect the same. Let’s see if that holds true:
Operating activities:
Net income $2.2 million
Increase in receivables (2 million)
Increase in inventory (2 million)
Increase in payables 1.8 million
Cash from operating activities $0.00 million
Investing activities:
Equipment purchased $(1.5 million)
Financing activities:
Loans advanced $2 million
Cash at beginning of period $0 million
Cash at end of period $0.5 million ($0 [operating]-$1.5 [investing]+$2 [financing]+$0 [opening])
Now your cashflow statement shows quite a different story. You have brought in no cash from your operations, despite having net income of $2.2 million. Worst than that, if your customers don’t sell the inventory they bought from you, you may not be able to collect the $2 million outstanding and you have another $2 million worth of inventory at your business. At the same time, your suppliers will likely not be as lenient and you will have to pay them the $1.8 million that is owed at the end of the year.
Are there other potential pitfalls?
Should you be unable to collect from your clients within the 30 days or so (depending on payment terms) and unable to sell additional inventory, you will need an additional $1.8 million in funding to pay your suppliers, while still owing $1 million to yourself, and an additional $1 million to the bank, bringing your total debt level to $3.8 million, or $3.3 million if you use the $0.5 million of cash that you have on hand.
What can you do to correct the situation?
1) The price of your items might be too high, perhaps a simple reduction in the price charged, and a discount to your customers, can help you collect the outstanding amount.
2) It appears that you have overestimated the demand for your product as you have $2 million worth of inventory remaining at your business. Should you stop producing products, until you sell the inventory you have on site, you will not incur costs relating to the products, which will prevent you from incurring additional payables
3) You may need to re-evaluate your products, perhaps a minor addition, or alteration may make it more desirable, giving your products higher demand and getting them off your customers shelves.
4) Consider selling directly to the consumers, either online, by setting up a storefront attached to your facility, and/or by placing ads, if you haven’t already done so.
Most importantly though, don’t panic, and this list is by no means exhaustive. But as you can see, there is a significant value to the cash flow statement, and it can readily identify issues that might be missed by strictly looking at the balance sheet and income statement.
For a business to be sustainable, you must generate cash from operations.
The next post on this topic will cover how to forecast cashflows.
The next post will use the same example with a different set of assumptions. It will show that having positive net income will not necessarily translate to positive cash.
Need help analyzing your current situation or looking to discuss any of your accounting or tax needs, then contact us.
This provides general information. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.
