Question

John Young is a new assistant controller at Richmond Electronics, a large regional consumer electronics chain. Before John’s recruitment, he was aware of Richmond’s long trend of moderate profitability. The reports on his desk confirm the slight, but steady, improvements in net income in recent years. The issue he is facing as he reviews the reports is the decline and erratic trend in cash flows from operations.

John sketched the following comparison ($ in millions):	Income from operations	Net income	Cash flow from operations
2014	$ 140.0	38.5	1.6
2013	$ 132.0	35.0	19.0
2012	$ 127.5	34.5	14.0
2011	$ 127.0	29.5	15.5

His sketch shows increasing profits but ominous trend in cash flow, which is consistently lower than net income. Upon closer review, Ben noticed three events in the last two years that, unfortunately, seemed related:

Richmond loosened its credit policy. In other words, Richmond relaxed its credit terms and lengthened payment periods.

Accounts receivable balances increased dramatically.

Several of the company’s compensation arrangements, including that of the controller and the company president, were based on reported net income.

What is so ominous about the combination of events John sees? If you were John, what course of action will you take?

Answer 1

John has observed that even though the net income is showing a slow but steady increase over the years , the cash flows are declining. He has further observed that the credit terms have been relaxed, the accounts receivable balances are increasing and compensation of several employees is based on the net income. It is ominous that the credit terms have been relaxed, so that the cash flow to the company is delayed resulting in a liquidity crunch. Further, accounts receivable balances have increased showing that there is no effort on the part of the employees to improve liquidity position. In addition, since the compensation contracts are based on the net income, employees are not focused in recovering the receivables to the company.

If I were John, I would take the following measures:

-I would tighten the credit policy to include less flexible credit terms.

-A program to recover the accounts receivables as fast as possible would be undertaken.

-The compensation contracts would be redesigned to ensure that a part of compensation is based on operating cash flow.