Question

The owner of Aurora Inc., Cindy Hickey, has come to you, a public accountant, for advice. “I am very worried about my business right now. My bank loan is at its maximum level, we have no cash, and my salary is backing up, unpaid. I don’t know what has gone wrong, and what I can do about it. Please provide some advice!”

Hickey’s company, Aurora, manufactures and distributes small, specialized boating items that have a good reputation and a stable market among pleasure boaters and fishers. She has been in business for ten years. Cindy reports, “The company showed a profit again this year. I hired a new part-time manager during the year so I could spend less day-to-day time on the operation. He has been building up our asset base. We sold some investments, but made no new ones. We replaced some inefficient machinery, and purchased a vehicle to save on rental expenses.
“We sold old machinery that would not be able to meet the demand that our new manager is projecting. It had a cost of $9,600, and net book value of $3,800. I think the amount I took out of the company was in line with that of previous years, although my salary is backing up, unpaid. I can’t afford that, I can tell you, but the company has no money to pay me.
“Our cash has dropped and we now owe a lot on a demand bank loan. I have some financial information for the year (Exhibit 1).”

 

“Can you explain what is happening with our cash flows? What should I do to get out of this hole?”

Required:

Respond to Cindy’s request.

Answer 1

Overview

 

The owner of Aurora, Cindy Hickey, has requested advice on cash flow issues. Aurora seems to be a small company, with a profitable history, but is currently in a cash crunch. Users of the financial statements include the bank, as there is a current demand loan, the owner of the company, The statements are presumably used for tax purposes.

 

Issues

 

1.      CFS

2.      Advice on cash flow issues

 

Analysis and recommendations

 

1.      CFS

 

A useful first step would be to prepare a Statement of Cash Flows. See Exhibit 1.

 

Although Aurora had $12,000 in net earnings, cash flows from day-to-day, or operating, activities translates into an outflow of $1,200. This was due in part to the increase in accounts receivable and inventory. 

 

The company sold investments during the year, a source of cash, but spent $16,000 on machinery and $27,500 on a vehicle. As a result, investing activities represented a cash outflow of $26,300.

 

In the financing area, the bank loan provided $30,000 in cash, but $8,000 of dividends were paid. 

 

2.      Advice on cash flow issues

 

There is a buildup in accounts receivable and inventory. Cindy should review these accounts to ensure that the receivables are collectible and the net realizable value of the inventory is not less than its carrying amount. There is also a major reduction in accounts payable, not consistent with the inventory buildup. Why was payment made so quickly? Are there valid business reasons as to why these balances are increasing? Could the increases to the assets have anything to do with the new manager and his practice of building up the asset base? How do accounts receivable turnover and inventory turnover compare to past years? This is a potential problem area to investigate.

 

The company has liquidity problem, but still has $20,000 of investments. If these were liquidated, the bank loan could be reduced and the cash flow problem would be addressed. Are there reasons that the investments are still held? This is a solution to investigate.

 

Acquisition of long-term assets should generally not be not financed with cash and demand loans. Financing of the vehicle and machinery should have been through debt that more closely matches the lives of the assets. Why was the machinery and equipment financed in such a way?

 

It might be more efficient for the company to own a vehicle as opposed to renting one, but the financial flexibility of the company has suffered. Using $43,500 to immediately pay for the vehicle and machinery limits Aurora’s cash flow flexibility in the future. In particular, the company has not owned a vehicle in the past. Who is driving the vehicle – Cindy or the new manager? This is a major investment for a small company. Perhaps the vehicle should be sold and another one leased?

 

A review of the Retained Earnings account indicates that $8,000 was taken in dividends during the year. (Net earnings were $12,000, while retained earnings increased by $4,000, so the difference would be attributable to dividends.) While the amount taken out of the company may be in line with past years, it represents a significant drain on Aurora’s cash. 

 

Conclusion

 

Aurora has been profitable, as is demonstrated by the relatively high amount of retained earnings. However, the company will need cash in order for the business to remain viable. Cindy should examine various existing financial statement elements with a view to solving the immediate cash problem. Cindy should develop a cash budget to plan for future asset acquisitions. 

 

All these issues should be discussed in conjunction with the new manager because Aurora’s liquidity has deteriorated during the year.

Exhibit 1

 

Aurora Inc.
Statement of Cash Flow
for the year ended December 31, 20XX
Operating activities:
Net earnings		12,000
Depreciation expense		9,200
Loss on sale of machinery		2,200
Gain on sale of investments		(3,600)
Increase in accounts receivable		(6,500)
Increase in inventory		(7,500)
Decrease in accounts payable		(10,100)
Increase in salaries payable		3,100
Cash from operating activities		(1,200)
Investing activities:
Sale of investments		15,600
Sale of machinery		1,600
Acquisition of machinery		(16,000)
Acquisition of vehicle		(27,500)
Cash used in investing activities		(26,300)
Financing activities:
Increase in demand bank loan		30,000
Payment of dividends		(8,000)
Cash from financing activities		22,000
Decrease in cash		(5,500)
Opening cash		6,000
Closing cash		500
Supplemental disclosures:
Cash received for interest		1,200
Cash paid for interest		(2,200)
Cash paid for income taxes		(2,750)

Supporting calculations:

Cost of investments sold		12,000
Gain on sale		3,600
Proceeds from sale		15,600

 

Book value of machinery sold		3,800
Loss on sale		(2,200)
Proceeds from sale		1,600

 

Machinery
Beginning		24,000
Cost of machinery sold		(9,600)
New machinery purchased		16,000
Ending		30,400

 

Retained earnings
Beginning		45,300
Net earnings		12,000
Dividends		8,000
Ending		49,300