net operating loss | Accounting Simplified - Part 2

Statement of Cash Flow

 
Accounting Simplified Book
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Business owners, creditors, and investors use the statement of cash flow to analyze the financial health of the business.

Business owners use the statement of cash flow to measure such activities as whether or not there is adequate cash on hand to pay debts, order inventory, purchase assets, or expand operations.

Creditors use the statement of cash flow to determine the solvency of the business, or the ability of the firm to pay its debts as they mature.

Investors use the statement of cash flow to determine how much cash is generated from operations to fund capital investments and pay down debt, in addition to the ability of the company to adapt to changing economic conditions, called financial flexibility.

Understanding the Statement of Cash Flow and Cash Flow Analysis

The statement of cash flow classifies the inflow and outflow of cash as cash flow operating activities, cash flow investing activities, and cash flow financing activities.

  1. Cash flow from operating activities refers to the cash generated or consumed from the primary operations of the business.

    • Collecting cash from customers is an example of a cash inflow from operating activities.
    • Payments to suppliers, employees, or paying rent are examples of cash outflows from operating activities.

  2. Cash flow investing activities refers to cash inflows and outflows from investments. Investing activities include lending money with interest, buying and selling assets, and buying and selling investments (e.g. stocks and bonds).

    • Collecting on a loan, selling assets, or selling investments are examples of cash inflows from investing activities.
    • Making a loan for cash, purchasing assets, or purchasing investments are examples of cash outflows from investing activities.

  3. Cash flow financing activities are those activities that allow the company to borrow money or obtain other forms of financing for operating the business.

    • Borrowing money or issuing stock to raise cash are examples of cash inflows from financing activities.
    • Repaying loans or paying dividends on stocks issued are examples of cash outflows from financing activities.

Each Statement of Cash Flow Section Answers the Following Questions:

Cash Flow Operating Activities

  • If a company has profitable operations, why is it short on cash?
  • If a company is operating at a net loss, why does it have a surplus of cash?

Cash Flow Investing Activities

  • Is the company using cash to acquire new equipment?
  • Is the company investing cash to expand operations?
  • Is the company obtaining cash from selling assets?
  • Is the company loaning cash?
  • Where is the company investing its cash? How much and where?

Cash Flow Financing Activities

  • Is the company financing asset purchases?
  • How much of the asset is financed?
  • Did the company use cash to pay off any of its outstanding loans used to finance the business?

Answers to these questions do not appear on the income statement and are not easily determined by analyzing the balance sheet.

Over the life of a company, the net cash increase or decrease will equal the total reported net income or loss. However, because the income statement and the balance sheet use the accrual accounting method and the statement of cash flows uses the cash accounting method, over the short-term net income will not equal cash flow.

Quality of Earnings refers to how closely income correlates with cash flow. The higher the correlation between net income and cash flow, the higher the earnings quality.

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Cash Flow Statement

 
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Cash Flow Definition

The cash flow statement, also called the statement of cash flows, summarizes the cash inflows and cash outflows from operating, investing, and financing activities for the reporting period indicated (e.g. a month, a quarter, or a year).

The cash flow statement is a required financial statement in addition to the income statement, the balance sheet, and the statement of stockholders equity.

Recall that the income statement reports revenue under the accrual accounting method. This means that sales that were made for the period were not necessarily made in cash. Similarly, any expenses incurred during the reporting period were not necessarily paid with cash.

The cash flow statement shows the actual flow of cash received and spent during the reporting period. It therefore uses the cash basis of accounting. Since the other financial statements use the accrual method, the statement of cash flows reconciles the financial statements to cash by identifying the actual cash paid for expenses, and the actual cash received for revenue.

The Cash Flow Statement and the Income Statement

The income statement summarizes the flow of business activity for the reporting period (a month, a quarter, or a year). This flow of business activity is categorized into revenue and expenses to determine net income.

Similarly, the cash flow statement summarizes the flow of cash activity for the reporting period. This flow of activity is categorized into inflows and outflows to determine the net cash increase or decrease. The income statement and the cash flow statement are therefore very similar in that they summarize the flow of activity for a certain period of time to determine the net result.

The Cash Flow Statement and the Balance Sheet

The accounting balance sheet shows us a “snapshot” of the results of that business activity frozen at certain point in time, including the cash balance. The net change in cash on the cash flow statement accounts for the change in the cash balance from one period to another on the balance sheet.

From these statements, we can develop a clearer picture of the financial health of the business. For example, even if a company is highly profitable compared to industry averages and competition, if the profits are not easily converted to cash, the business may have problems paying for inventory, bills, and staying afloat. It is therefore essential that the profit and loss statement is examined with the cash flow report and the balance sheet to develop a complete picture of the business.

The Cash Flow Statement Includes Cash and Cash Equivalents

According to Generally Accepted Accounting Principles (GAAP), the statement of cash flows must include cash and cash equivalents. Cash equivalents are defined as short-term, highly liquid investments that are readily convertible to known amounts of cash.

Because cash equivalents are so near their maturity dates, they present an insignificant risk of changing in value. Generally, only investments with original maturities of three months or less qualify as cash equivalents (FASB Statement No. 95).

Examples of cash equivalents

  • Treasury Bills
  • Money Market Funds
  • Commercial Paper (short-term loans)
  • Certificates of Deposit
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Gross Profit Margin

 
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The gross profit margin is the amount left over from sales after the cost of goods sold is subtracted.

Gross profit is the earliest measure of business strength before operating and other expenses are subtracted.

 

 

How to Calculate Gross Profit Margin

Gross Margin = (Sales – COGS)/Sales

Sunny sells a pair of sunglasses for $50 retail. Sunny is able to purchase these sunglasses for $15 each wholesale (COGS). Sunny Sunglasses Shop therefore made a healthy gross profit of $35 (50 – 15 = 35). This translates into a strong gross margin of 70% (35/50 = 70%).

In analyzing how Sunny achieved a net profit in his business, the gross profit margin is a key measurement. Sunny managed to negotiate a competitive wholesale price for a quality product that retails for $50.

A strong gross margin is crucial to business success since it represents profit before operating expenses and taxes enter the picture. Let’s see how Sunny Sunglasses Shop’s gross profit margin compares with other companies and its industry, Specialty Retail, Other:

Industry Ratios: Gross Profit Margin

Company Average Gross
Profit Margin
Microsoft 77.2%
Software Industry 75.6%
Sunny Sunglasses Shop 70%
Sunglasses Hut Int. (Luxottica Group) 65.6%
Specialty Retail, Other 42.5%
S&P 500 39.6%

Sunny wisely selected a business with a strong gross margin, getting his profits off to a jump-start before operating expenses and taxes. It is right in line with his closest and largest competitor, Luxottica, and well ahead of the industry average of 42.5% for Specialty Retail.

Information Products and Strong Gross Margins

Many software companies, or makers of other information products, have strong gross margins because the cost of goods sold is very low in comparison to other industries that require more expensive inventories.

Microsoft is known for its strong gross margins of around 80%! The software industry average is 75.6%, while the S&P 500 average is 39.6%!

A strong gross profit margin is essential to getting a jump-start on profits, and should be one of the first considerations in starting your business!

Sunny should monitor this key indicator of gross profits from year to year to ensure he remains profitable, and note any reasons why his gross margins are going up (e.g. wholesale discounts, in demand products and higher prices) or down (e.g. more expensive inventory, discounted retail items, and lower demand for products).

A small percentage of Sunny Shop’s customers will return products sold. Note that gross profit is divided by sales after returns, or net sales, not gross sales.

Sunny selected a business with an impressive gross margin. His next step is to make sure he holds on to his profits by controlling operating expenses.

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