Business Activities and Working Capitals' Influence on Business Cash Flow
 
 

Business Activities and Working Capitals' Influence on Business Cash Flow

Impact of Working Capital and Activities on Cash Flow Overview:

Many accountants and business owners consider cash flow to be the lifeblood of a healthy business. There are two primary critical measures for company to have the ability to meet its financial obligations and they are called cash flow and working capital. During the course of a business cycle company may generate significant amount of profit but they might have insufficient amounts of cash. Cash is generally regarded as the most liquid of all assets that a business can own so many managers and business owners have a particular interest in exactly how much cash is available to their business at any given time.

Theoretically the flow of cash both into and out of a company can be considered as just a matter of investing (purchasing assets) as well as divesting (getting rid of assets) therefore an analysis of cash flows can help measure the overall performance for a business. Through analyzing the cash flow of a business as well as the working capital business owners and managers can then determine whether or not the business will be able to pay its upcoming liabilities. In this article we will try to go through the process and mechanisms of accounting for cash flow and analyzing cash flow. Even though the statement of cash flow doesn't replace the income statement or the balance sheet it is still considered to be a very useful adjunct tool that allows you to perform various types of analysis and helps to establish cash flow relational links regarding the activities of a business.

Learning Objectives

• You should be able to describe the differences between cash flow and working capital.

• You should be to analyze and perform adjustments based on the in-flows and out-flows of cash to a company.

• You should be fundamental understand and describe the account cycle process and how it interacts with cash flow and working capital.

Cash Flow vs. Working Capital:

When talking about cash flow generally most people are referring to the amount of cash the business will generate over a specified amount of time. Cash flow for a business will almost never equal the net profit because companies usually sell on credit and tend to borrow money. Additionally when cash is generated through sales it can be reinvested into the business to further business activities or it can be reinvested into other assets such as stocks and bonds or real estate. Therefore it is not accurate for somebody to simply try and compare the cash on hand for a business at the beginning of the accounting period and then again at the end of the accounting period determine cash flow.

When using the term working capital most people are referring to the difference between the current assets and the current liabilities. To turn current assets the first of those things that the business owns or controls which can be turned into cash in 12 months or less, and the current liabilities refer to the line into obligations that a business has which are due in 12 months or less. Both of these figures are reported in the balance sheet for a business which makes calculating the working capital fairly simple. Often a large amount of working capital implies that a business has sufficient assets to be able to cover or pay the liabilities that are due in the short-term future of 12 months or less. When a business has negative working capital this implies that the business cannot pay its bills in the short term and will not have enough money through the collection of its account receivables or other assets in order to pay its financial obligations.

The major differentiating factor between cash flow and working capital is that the working capital provides a snapshot of the present financial situation while cash flow is generally just a measure of the company's ability to generate cash over the specific accounting period or a specified time frame. The quarterly cash flows will be very different for the most part than the amount of cash the business will generate over a yearlong period. As a result of these differences the working capital will provide the business owner or manager a good idea of how easily the business can pay its immediate liabilities, and cash flow give the business owner more of a forward-looking perspective on the amount of cash generated over time. In many businesses that operate under normal conditions they can have high cash flow and also have high working capital. However there can also be various other factors that will result in a divergence of these measures. For example if a business begins investing in equipment or facilities, pay old or outstanding debt that was acquired long ago, were paying dividends to stockholders then these activities have the ability to drain cash and working capital even if the business is able to generate large amounts of cash through the regular operating activities. Conversely, raising cash and borrowing money will actually add to the cash position of a business as well as to the working capital position even though the company is not able to generate much cash through their ordinary activities.

Analyzing Adjustments and Transactions of Cash Flow on Working Capital:

In order to understand the effects of cash flow on working capital is important to understand how financial statements report these items, and how they are adjusted throughout the accounting cycle. In order to prepare statements for analysis companies will translate their day-to-day transactions into journals, which is another term for accounting records, and then they will post (record) them into individual accounts. At the end of the accounting cycle for each period these accounts are totaled and then the resulting balances and information derived from those balances are used in the preparation of financial statements.

Both the balance sheet and income statement for business are generally prepared using the accrual method of accounting where the revenues are recognized when they are earned and expenses are recognized when they are incurred. This then implies that a business can report income even though it has not received any cash yet. Due to this there can be cash shortages for a business in which a business will run into unexpected cash outlays or situations where customers either refuse to pay or simply cannot pay thereby creating financial burdens for a business they can even result in bankruptcy. When analyzing cash flow it's important to start by assessing how the company manages its cash. The income statement provides the user information regarding the financial strength or viability of the products and services offered by business. The income statement has the ability to explain whether or not a business can sell its products for its services at prices that will cover its costs and still provide a reasonable return for its stockholders or lenders to the business. Conversely as previously explained the statement of cash flow will provide information about the company's ability to generate cash from those same transactions.

Effects of Cash Flows on Working Capital and the Financial Statements:

The three types of activities that can generate cash flow. Those three streams of cash flow activities are referred to as:

Cash Flows from Operating Activities- Cash flows generated from operating activities are derived from the transactions and events that relate to the daily operations of a business.

Cash Flows from Investing Activities- Cash flows are generated from both the acquisition and the divestiture of long-term assets as well as other investments that the business has strategically acquired or sold to produce cash flows.

Cash Flows from Financing Activities- Cash flows in this category are cash flows that have been generated from both the issuance of equity as well as payments toward borrowings that have been made by a company.

When these three sections of cash flow based activities are combined they will yield the overall net change in cash for the business over a given accounting period. It is important to remember that the three sections of the statement of cash flows have a direct relation to both the income statement and to different components of the balance sheet. Shown below is a table that lists the relationship linkages and highlights them in red. Study the table and view how the three sections generally make connections using the following information:

Net Cash Flows from Operating Activities- The net cash flows from operating activities tend to relate the current assets from the balance sheet as well as the current liabilities from the balance sheet to the income statement.

Net Cash Flows from Investing Activities- The net cash flows from investing activities establishes a relationship between the long-term assets of the balance sheet.

Net Cash Flows from Financing Activities- The net cash flows from financing activities establish a relationship to both the stockholders' equity component of the balance sheet as well as the long-term liabilities component of the balance sheet.

Information from

Cash Flow Section

Income Statement

Information from the Balance Sheet




Net Cash Flow from


Revenues

Current Operating Assets

Current Operating Liabilities

Operating Activities

(-) Expenses

Long-term operating and all

Long-term operating and all


(=) Net Income

non-operating assets

Non-operating Liabilities



Equity




Net Cash Flow from


Revenues

Current Operating Assets

Current Operating Liabilities

Investing Activities

(-) Expenses

Long-term operating and all

Long-term operating and all


(=) Net Income

non-operating assets

Non-operating Liabilities



Equity




Net Cash Flow from


Revenues

Current Operating Assets

Current Operating Liabilities

Interested in learning more? Why not take an online class in Understanding Financial Statements?

Financing Activities

(-) Expenses

Long-term operating and all

Long-term operating and all


(=) Net Income

non-operating assets

Non-operating Liabilities



Equity

Computations for Cash Flow:

In business it can sometimes prove to be difficult to understand why certain accounts are either subtracted from or added to the net income to yield the net cash flows from operating activities. If you have to read the section more than once don't worry or feel bad because even seasoned accountants and business professionals can struggle with grasping how this component of the statement of cash flows are constructed. In time this will prove to be easy, just remember to go slowly and take things step by step by breaking the financial statements down into smaller pieces and seeing how the relationships work it can make the task much less daunting to learn. One of the keys to understanding these computations is to also remember that when using accrual accounting the revenues are recognized when they are earned and expenses are recognized when they are incurred. This recognition accounting treatment does not necessarily coincide along with the receipt of cash for payment of cash. The net income also referred to as the top line of the operating section of the statement of cash flows represents the net (accrual) income under the Generally Accepted Accounting Principles (GAAP). The net cash flows from operating activities also referred to as the bottom line shows the cash profit that a business would have reported if it had constructed its income statement using a cash basis rather than an accrual basis. When computing the net cash flows from operating activities the process begins with GAAP profit and then adjusts it to compute the cash profit using the following method shown in the sample statement below.

Cash Flow Computations

Add (+) or Subtract (-)

from Net Income



Adjustments for noncash



revenues, expenses,


Net Income………………………………………………

$ #

gains and losses

Add: Depreciation Expenses……………………

+



Adjust for changes in current assets

Adjustments for changes

Subtract increase in current assets……..

-

in noncash current assets

Add decreases in current assets……….

+

and current liabilities

Adjust for changes in current liabilities

Add increase in current liabilities………

+

Subtract decrease in current liabilities

-




Cash from operating activities

$ #

Generally the net income is first adjusted for non-cash expenses for things like depreciation and then it is adjusted for changes that occur in the current assets and current liabilities during the accounting period in order to yield cash flow from operating activities which is also referred to as cash profit. The depreciation adjustment simply zeros out or undoes the effect of the depreciation expense, which is then subtracted, or rather the ducted in solving for the net income. The table below is designed to help give you brief explanations and clarify adjustments for receivables, tables and accruals, and inventories that are generally most often the sources of adjustments in this analysis.

Change in

Which Requires This

Account

Adjustment to Net Income

Balance…

Implies That…

To Yield Cash Profit…

Receivables

Increase

Sales and net income increase,

Deduct increase in receivables

but cash is not yet received

from net income

Decrease

More cash is received than is

Add decrease in receivables

reported in sales and net income

to net income

Inventories

Increase

Cash is paid for inventory that is

Deduct increase in inventories

not yet reflected in Cost of Goods Sold

from net income

Decrease

Cost of Goods Sold includes inventory

Add decrease in inventories

costs that were paid for in a previous period

to net income

Increase

More goods and services are acquired on

Add increase in payables and

Payables and

credit, which delays cash payment

accruals to net income

Accruals

Decrease

More cash is paid than is reflected in Cost

Deduct decrease in payables and

of Goods Sold or Operating Expenses

accruals from net income

Below there is also listed a helpful decision guide that shows a succinct version of the changes in assets, liabilities, and equity in order to get a better grasp on the direct increase or decreases to cash flows for a business.

Cash Flow Change Decision Guide

Cash Flow Increase From

Cash Flow Decreases From


Assets

Account Decreases

Account Increases

Liabilities and Equity

Account Increases

Account Decreases

KEY POINTS REVIEW

  • The major differentiating factor between cash flow and working capital is that the working capital provides a snapshot of the present financial situation while cash flow is generally just a measure of the company's ability to generate cash over the specific accounting period or a specified time frame.
  • The flow of cash both into and out of a company can be considered as just a matter of investing (purchasing assets) as well as divesting (getting rid of assets).
  • The income statement provides the user information regarding the financial strength or viability of the products and services offered by business.
  • The net cash flows from operating activities tend to relate the current assets from the balance sheet as well as the current liabilities from the balance sheet to the income statement.
 
 
Popular Courses
 
Learn More! Take an Online Course...