Question

Why a company with very high net profits can still be in cash flow problems? List and explain three
main reasons using examples

Answer 1

A company having high net profits may still have cash flow problems because cash is used in many activities other than operations such as Investing and Financing activities.

Cash may be used in paying debts of the company or in prepaid expenses or in purchasing of fixed assets.

Various examples which may result in cash flow problem even in high net profits are given below

1. Cash used in investing activities such as purchase of investments or fixed assets. Generally cash is used in investing activities due to expansion strategies of the companies. Cash used in investing activities reduces the cash flow and even reduce overall cash generated throughout the year.
2. Cash used in financing activities such as payment of Dividends, redemption of long term liabilities, Drawings by Owners, etc result in cash problems even if operating income is high.
3. Uncollected cash from receivables. When the balance of Accounts receivables increase it means cash is unpaid by the receivables which may create cash problems.

A pro-forma cash flow is given below to understand this situation clearly.

Cash Flow Statement
For the ended December 31
Cash Flow from Operating Activities:
Net Income		$    177,626.00
Add: Adjustments
Depreciation expense	$      26,750.00
Decrease in Accounts Payables	$    (64,534.00)
Increase in Accounts receivables	$    (77,205.00)
Increase in Inventory	$    (26,856.00)
Increase in Prepaid Expenses	$          (745.00)
		$ (142,590.00)
A. Cash Flow from Operating Activities		$      35,036.00
Cash Flow from Investing Activities:
Sale of Equipment	$      17,625.00
Purchase of Equipment	$    (42,000.00)
B. Cash flow from Investing Activities		$    (24,375.00)
Cash Flow from Financing Activities:
Dividend paid	$    (51,300.00)
Proceeds from short term notes payable	$        4,600.00
Retirement of long term notes payable	$    (53,125.00)
C. Cash Flow from Financing Activities		$    (99,825.00)
Increase (Decrease) in cash [A+B+C]		$    (89,164.00)
Add: cash at the beginning of the year		$      99,836.00
Cash at the end of the year		$     10,672.00

As it can be seen in the above cash flow Net income of the company is $177626 but still final cash balance is $10672. Cash is used by Investing activities is $24375 an Cash used by Investing activities is $99825.