Question

You are a loan officer for First Benevolent Bank. You have an uneasy feeling as you examine a loan application from Daring Corporation. The application included the following financial statements.

DARING CORPORATION Income Statement   For the Year Ended December 31, 2018
Sales revenue	$100,000
Cost of goods sold	(50,000)
Depreciation expense	(5,000)
Remaining expenses	(25,000)
Net income	$ 20,000
DARING CORPORATION Balance Sheet December 31, 2018
Cash	$ 5,000
Accounts receivable	25,000
Inventory	20,000
Operational assets	55,000
Accumulated depreciation	(5,000)
Total	$100,000
Accounts payable	$ 10,000
Interest payable	5,000
Note payable	45,000
Common stock	20,000
Retained earnings	20,000
Total	$100,000

It is not Daring’s profitability that worries you. The income statement submitted with the application shows net income of $20,000 in Daring’s first year of operations. By referring to the balance sheet, you see that this net income represents a 20% rate of return on assets of $100,000. Your concern stems from the recollection that the note payable reported on Daring’s balance sheet is a two-year loan you approved earlier in the year.

You also recall another promising new company that, just last year, defaulted on another of your bank’s loans when it failed due to its inability to generate sufficient cash flows to meet its obligations. Before requesting additional information from Daring, you decide to test your memory of the intermediate accounting class you took in night school by attempting to prepare a statement of cash flows from the information available in the loan application.

Answer 1

DARING COMPANY

Statement of Cash Flows of for the year ended December 31, 2018

particulars	($ in 000's)	($ in 000's)
Cash flows from operating activities:
Cash inflows
From customers($100-25)	$75
Cash outflows
To suppliers of goods ($50+20-10)	($60)
For remaining expenses($25-5)	($20)
Net cash flows from operating activities		($5)
Cash flows from Investing activities:
Purchase of depreciable assets(given)		($55)
Cash flows from Financing activities:
Issuance of note payable	$45
Issuance of common stock	$20
Net cash flows from financing activities		$65
Net increase in cash		$5
Cash balance, January1		0
Cash balance,December 31		$5

Your concerns are justified in the sense that cash flows are insufficient to cover existing interest charges, not to mention additional charges from new debt. In fact,the principal on the debt of $45000 will come due shortly in addition to additional interest. Altough net income is possitive, cash flows from operating activities are negative. A difference between cashflows and net income can exist due to the way the two items are measured.Net income, measured on an accural basis, is the difference between the revenues earned during the reporting period , regardless of when cash is received, amd the expenses incured in generating those revenus, regardless of when cash is paid. cashflows from operating activies are inflows and outflows of cash resulting from the same activities that are reported on the income statement.

On the other hand, the negative cash flow from operations is not reason, in and itself, for rejecting the application. Profit is positive the reason net income is measured on an accural basis rather than a cash basis is that very often, net income is a better indication of performance, particularly long-term performance than cashflow. However, many promising companies that have reported profits have failed due to cash shortages. Good business managers understand the bottom line net income has little to do with remain afloat and also avoid financing charges caused by having to undertake emergency borrowing, as in ther case here.

The bottom line is that additional information is needed. One cause of the negative operating cash flows is the acquisition of a large amount of inventory that is unsold. If product demand is strong, this is favorable. Why sre those inventories unsold? What is the projected growth rate in revenues? Another cencern may be the rather high balance in accounts receivable. Cash collected from customers was only 75% of sales for the year. Is credit policy too lax? On the other hand, if the uncollected receivables arose primarily as a result of heavy year-end sales ans are eminentlty collectible, The cashflow situation will benefit. Another practical consideration is the fact that the bank already has a $45000 investment in this new company, an investment that likely will be lost if the company is denied the new funds it seeks.