Question

The partner in charge of the James Spencer Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the statement of cash flows for the year ended December 31, 2020. Because he must leave on an emergency, he asks you to finish the letter by explaining (1) the difference between the net income and cash flow amounts, (2) the importance of operating cash flow, (3) the sustainable source(s) of cash flow, and (4) possible suggestions to improve the cash position. Spencer is a small corporation that relies on its auditor for financial statement preparation.

Cash flows from operating activities
Net income		$ 100,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense	$  11,000
Loss on sale of fixed assets	5,000
Increase in accounts receivable (net)	(40,000)
Increase in inventory	(35,000)
Decrease in accounts payable	(41,000)	(100,000)
Net cash provided by operating activities		–0–
Cash flows from investing activities
Sale of plant assets	25,000
Purchase of equipment	(100,000)
Purchase of land	(200,000)
Net cash used by investing activities		(275,000)
Cash flows from financing activities
Payment of dividends	(10,000)
Redemption of bonds	(100,000)
Net cash used by financing activities		(110,000)
Net decrease in cash		(385,000)
Cash balance, January 1, 2020		400,000
Cash balance, December 31, 2020		$  15,000

Date
James Spencer III, CEO
James Spencer Corporation
125 Bay Street
Toronto, ON

Dear Mr. Spencer:

I have good news and bad news about the financial statements for the year ended December 31, 2020. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how both of these situations occurred at the same time …

Answer 1

Date

James Spencer, III, CEO
Spencer Corporation
125 Bay Street,
Toronto, ON

Dear Mr. Spencer:

I have good news and bad news about the financial statements for the year ended December 31, 2020. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows which best illustrates how both of these situations occurred at the same time.

If you look at the operating activities, you can see that all of the cash generated by operations was used to increase inventory and to substantially reduce the accounts payable. Compounding this problem was the fact that credit sales exceeded collections on account. While these are necessary activities, the three combined to reduce your cash balance by $116,000. Two activities, which are incompatible with each other, are the increases in inventory with the decreases in accounts payable. You might want to check into any changes in your business practices that have caused this unlikely combination.

The corporation made significant investments in equipment and land. These were paid from cash reserves. While it is good that no monies were borrowed against these assets, these purchases used 75% of the company's opening cash. In addition, the redemption of the bonds improved the equity of the corporation and reduced interest expense. However, it also used 25% of the corporation's opening cash. It is normal to use cash for investing and financing activities. But when cash is used, it must also be replenished, and acquisition of plant assets is normally financed using equity or long-term debt financing, not through the depletion of cash on hand. The duration of the assets’ productive lives should be matched with the duration of the debt.

Operations normally provide the cash for investing and financing activities. Since there is a finite amount of assets to sell and funds to borrow or raise from the sale of capital shares, operating activities are the only renewable source of cash. That is why it is important to keep the operating cash flows positive. Cash management requires careful and continuous planning and monitoring.

There are several possible remedies for the current cash problem. First, prepare a detailed analysis of monthly cash requirements for the next year. Second, investigate the changes in accounts receivable and inventory and work to return them to more normal levels. Third, look for more favourable terms with suppliers to allow the accounts payable to increase without loss of discounts or other costs. Finally, if the land was purchased outright for a $200,000 total cost, consider shopping for a low interest loan to finance the acquisition for a few years and return the cash balance to a more normal level.

If you have additional questions or need one of our staff to address this problem, please contact me at your convenience.

Sincerely yours,

Partner in Charge.