Cash Flows
The Statement of Cash Flows shows information related to all cash inflow and outflows from three main activities namely operating activities, investing activities and financing activities. It disclose the cash generated or used by a company in a given period. Cash flows statement is important since cash is an important component of a company. Without having enough cash, copmany will face going concern problems.
A good company may be reflected through a good cash management. Thus, cash should flow smoothly in and out of the company which we can see from the cash flows statement. Cash flows statement can help us in measuring the profitability of a company by looking at the net cash flows. Holding plenty of cash is usually seen as bad cash management. It should be invested to generate income rather than keep it withaout any benefit arise. However, too much outflows can lead to cash problems and will effect the company's stability. Thus, cash management is very important for a company to stay health and profitability.
Cash is king and is the blood of a business - it has to flow evenly. Cash flow is calculated by adding and subtracting certain items to the net income. These adjustments must be made because non-cash items may be included into the net income even though it does not represent any cash in the bank.
e.g. You sell an item with a condition that the buyer can use it for 30 days, and if they like it, they pay for it. Otherwise they return it during the 30 day period without paying anything. In this case, accounts receivables will go up which makes it seem like the assets have increased, but in cash terms, you did not receive a single cent. Thus the importance of seeing how this number is stated in the statements.
Accounts Receivable
If accounts receivable decreases from the previous years (you have to compare by going back a few years), this means that more cash has entered the company from customers paying off their credit accounts. If accounts receivable increases, this means that the company has sold more products that money received.
In AeroGrow's latest filing 10-Q filing (see above), we see that the cash related to accounts receivable decreased by $9.9 million compared to a decrease of $3 million a year ago. In other words, AERO sold $9.9 million worth of goods without being paid, compared to $3 million the prior year. They are both bad numbers, but the latest increase is a whopping 330%!
This is a huge warning sign that management is desperately, in a maniacal way, trying to get their products onto any available shelf. Far too aggressive.
Inventory
Same for inventory, which they burned $5.7 million on. Rather than managing it, they've multiplied it like cockroaches. They currently have $8.5 million in finished goods which I assume is supposed to meet the demand they were expecting, except they have announced an expected slow down.
It would have been better to keep it as raw materials and streamline assembly processes in order to meet demand. Raw materials could be sold at commodity prices if it came down to it, but finished goods collecting dust will only fetch 50% at best in a fire sale.
Good indicator that management is unrealistic with performance and does not perform proper market research.
(If raw materials increase but finished goods decrease, it means the company has a problem with efficiency, processes and ultimately meeting demand.)
Accounts Payable
The third big warning sign is accounts payable. Since this is a positive number, the cash hasn't left yet, so it's been added back to net income because it is stated as a liability in the Balance Sheet.
This means that AERO has delayed the payment but will have to pay this huge amount in another period. An increase of $7.7 million in payables will surely require the company to look for further credit or dilute shareholders in order to pay it down.
Cash From Operations
For a company to be healthy, the cash from operating activities should be positive, but the quality of the cash is just as important.
The net income at the top of the Cash Flow Statement should preferably be a high positive number and the adjustment differences should not be huge. If this is the case, the majority of cash from net income should drop to the Cash from Operations line.
We see AeroGrow went from a net income of $(2.4 million) to Cash Used in Operations of $(9.2 million) in 6 months. This is $2 million more than the previous year and considering the size of the company, this is a first degree burn.
You can also see the company spending to purchase new equipment and receiving $9 million from financing with over $10 million in debt from $0 one year ago. Not the quality we want to see. Unsuspecting investors may only see the Cash at Beginning of Period of $1.6 million and Cash at End of Period of $0.4 million and think they used up $1.2 million. But we can see the true number is $9.2 million.
Not to mention a $8 million market cap with $10 million in debt and more coming.. you do the math.
Conclusion
The latest news from AERO touts its first every profitable quarter masked behind a mess of cash outflows. We've just seen why it's more important to view cash than earnings.
I don't mean to pick on AeroGrow, and the company will hate me for writing this, but before getting into the details of ROE, ROA, margins, solvency, turnover etc, taking a quick glance at the statements will reveal the company for what it is and save you from deep trouble.
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Managing Cash Flow
Knowing how to measure cash flow is just one of the skills you need to manage the cash flow of your business. The statement of cash flow shows you where your cash comes from, where you spend it, and the net change in cash for the year. Understanding how the cash "flows" through your business can help you to forecast and manage your business. To manage cash flow effectively, you must follow the operating cycle of your business and see how to use the operating cycle to forecast cash flow in the future.
Operating Cycle
The operating cycle measures the length of time that it takes a business to convert cash outflows for raw materials, labor, etc., into cash inflows. This cycle will determine, to a large extent, the amount of capital necessary to start and operate your business. The operating cycle consists of three sub-cycles:
Accounts receivable cycle
Inventory cycle
Accounts payable cycle
Accounts Receivable Cycle
The accounts receivable cycle measures the length of time it takes a business to convert a sale into cash. In other words, how long does it take a business to collect its accounts receivable.
The following diagram depicts the cycle:
Sale -> Accounts Receivable -> Cash
One way to measure the length of time it takes to convert a sale into cash is by calculating the number of days of cash receipts invested in accounts receivable.
The calculation consists of two steps:
1. Calculate average daily sales:
Average daily sales =
Annual Sales
------------------
360*
2. Calculate average daily sales in accounts receivable:
Average days of sales in accounts receivable =
Accounts receivable
-----------------------
Average daily sales
*Accepted accounting practice calculate the number of days in a year at 360 (30 per month x 12 months). This is the common figure to use when calculating daily averages based on annual figures.
Using information from Best Company (accrual basis), you know that the total sales for the company is $1200 ($400 cash sales + $800 sales on account). So the average daily sales is calculated:
$1200
----------
360
= $3.3 daily sales
You also know that accounts receivable at the end of the year was $200 ($800 sales on account &endash; $600 collections on accounts). So the average daily sales in accounts receivable is calculated:
$200
----------
$3.3
= 60 days
Inventory Cycle
The inventory cycle measures the length of time it takes your business to convert inventory into cost of sales. This represents the number of days of cash invested in inventory.
The following diagram depicts the cycle:
Cash -> Inventory -> Cost of Sales
One way to measure the length of time it takes to convert inventory into cost of sales is by calculating the average number of days of cost of sales in inventory.
The calculations consist of two steps:
1. Calculate average daily sales:
Average daily sales =
Annual Sales
------------------
360*
2. Calculate average daily sales in accounts receivable:
Average daily cost of sales in inventory =
Inventory
-----------------------
Average daily cost of sales
Using information from Best Company (and assuming cost of sales is 60% of sales), the average cost of sales per day is calculated:
$720
----------
360
= $2.0 daily cost of sales
The average daily cost of sales in inventory (assuming inventory is $200) is calculated:
$200
----------
$2.00
= 100 days
Accounts Payable Cycle
The accounts payable cycle measures the length of time it takes your business to pay its accounts payable. It represents the number of days of cash financed by your creditors. The following diagram depicts the cycle:
Cash -> Accounts Payable
One way to measure the length of time it takes a business to pay its accounts payable is by calculating the average number of days of cost of sales in accounts payable.
The calculations consist of two steps:
1. Calculate average daily cost of sales:
Average daily cost of sales =
Cost of Sales
------------------
360*
2. Calculate average daily sales in accounts receivable:
Average daily cost of sales in accounts payable =
Accounts payable
-----------------------
Average daily cost of sales
Again, using the Best Company as an example and assuming the average daily cost of sales is $2.00, the average daily cost of sales in accounts payable is calculated:
$100
----------
$2.00
= 50 days
The operating cycle is the sum of the sales and inventory cycles less the accounts payable cycle. It represents the length of time from when a business purchases materials and other costs of production to make a product until the time the business collects the accounts receivable from the sale of the product, reduced by the financing of the costs of production by the business's vendors.
The cash cycle for the Best Company is calculated:
Days
Accounts receivable cycle
60
Inventory cycle
100
Accounts payable cycle
(50)
Operating cycle
110
The business has 160 days of sales invested in its accounts receivable and inventory. If vendors are financing 50 days of sales, owners of the business must finance the remaining 110 days with capital, either loans or equity.
The operating cycle is dependent on a number of factors including the business's credit and collection policies, the business's inventory management policies, and the business's credit rating and payment patterns. The business can shorten it's operating cycle by implementing or strengthening the policies and procedures in these areas.
Forecasting Cash Flow
An accurate cash flow forecast requires an understanding of the financial statements of the business and a good sense of how different accounts relate to one another. For instance, you should know how accounts receivable are correlating with sales, or how expenses correlate with accounts payable.
Using the Best Company as an example, we can prepare an simplified cash flow forecast using the following assumptions in developing a cash flow forecast:
Assumptions:
Sales
10% growth
Cost of sales
60% of sales
Fixed expenses
$250
Depreciation expense
$150
Interest income
$100
Proceeds on equipment sales
$-0-
Equipment purchases
$500
Tax rate
40%
All other accounts
Expected to remain the same as in year 1
The forecasted income statement of the Best Company is expected to be as follows:
Sales
$1320
Cost of sales
528
______
Gross profit
660
Operating expenses
150
Depreciation
150
______
Total expenses
300
Operating income
360
Interest income
100
Income before taxes
460
Income taxes
184
______
Net income
$276
Cash Flow Statement (Indirect method):
Operating Activities:
Net income
$276
Add: non-cash items depreciation
150
Changes in current assets and liabilities
Accounts receivable
(20)
Inventory
(20)
Accounts payable
10
Cash received from operations
396
Investing Activities:
Equipment purchases
500
________
Net change in cash before financing activities
$(104)
In this example, Best Company knows that it must arrange financing of $104 o cover cash shortage for next year's forecasted operations. The cash flow forecast allows the business to plan ahead and anticipate cash flow shortages.
Most forecasts are based on a business's financial history. They can be projected from a month's, a quarter's or a year's worth of financial records. If you are just beginning your business, you can still do worthwhile projections. Certain industry standards exist for many businesses from which to do projections. Consult RMA Annual State Studies (Robert Morris Associates: Philadelphia, Penn.) or Almanac of Business and Industrial Ratios (Leo Troy, PhD, Prentice Hall: Englewood Cliffs, N.J.)
Summary
As you can see, many factors influence the cash flow of a business. Understanding the concept of cash flow and how to measure it will help you become more competitive, improve performance, and ultimately make your business successful. A business owner who is forecasting accurately his or her cash flow can be very effective at managing expenses because he or she can keep the accounts payable cycle as long possible and the accounts receivable cycle as short as possible. He or she can keep the cost of producing the product down by planning ahead of time when to buy inventory. Fine-tuning the operation cycle keeps a business as efficient as possible.
Identifying cash shortages will allow you to line-up the necessary financing in advance and give you time to negotiate the most favorable loan rates. Nothing will impress a banker more-when you approach him or her for financing-than a careful cash flow analysis that can show precisely why you need $104 (or whatever amount) in the next year to keep your business healthy. And identifying periods of excess cash will allow you to place the cash in less liquid investments that will pay higher interest rates than checking accounts.
Cash flow management allows you to plan for unexpected increases in cost production. Unless you can absorb some of the cost increases, you will have to add the costs on to your product. And that can be a very dangerous proposition. Ideally, the marketplace will determine the cost of your product so you can be competitive. If you have to raise your prices because your production costs are going up, you can lose a valuable competitive advantage and price yourself out of business. It's happened to more than a few businesses. In a lot of these cases, keeping an eye on the "scoreboard" might have allowed for timely adjustments to production and cash flow management.
Don't leave this stuff to the bean counters! Understand what is happening with the money-the life blood of a business-as it flows in and out of your business.
Cash flows measures a company's
