Prepare a statement of cash flows for 2010 using the direct method in the operating activites section…….
On the bases of your statement in (1), draft a brief memo to the president to explain why cash decreased during such a profitable year. Include in your explanation any recommendations for inproving the companys cash flow in future years.
Other information is as follows:
a. Dividends of $60,000 were declared and paid during the year.
b. Operating expenses include $50,000 of depreciation.
c. Land and plant and equipment were acquired for cash, and additional stock was issued for cash. Cash also was received from additional bank loans.
The president has asked you some questions about the year%u2019s results. She is very impressed with the profit margin of 18% (net income divided by sales revenue). She is bothered, however, by the decline in the company%u2019s cash balance during the year. One of the conditions of the existing bank loan is that the company maintains a minimum cash balance of $50,000.
Required
- Prepare a statement of cash flows for 2012 using the direct (and indirect) method in the Operating Activities section.
- On the basis of your statement in part (1), draft a brief memo to the president to explain why cash decreased during such a profitable year. Include in your explanation any recommendations for improving the company%u2019s cash flow in future years.
NOTE: The original answer to this is wrong/incomplete (so don’t copy and paste it).
The Correct Answer and Explanation is :
To assist you with preparing the statement of cash flows and a memo for the president, let’s go through the steps involved.
Step 1: Prepare the Statement of Cash Flows (Direct Method)
The statement of cash flows consists of three sections: operating activities, investing activities, and financing activities. Since you are specifically asking for the operating activities section, let’s focus on that.
Direct Method – Operating Activities
Operating activities under the direct method involve presenting cash receipts and payments from operating activities, as follows:
Cash Received from Customers:
- You need to adjust sales revenue for any changes in accounts receivable. Based on the information provided, this would be:
- Cash received from customers = Sales revenue + Decrease in accounts receivable (or – Increase in accounts receivable)
Cash Paid to Suppliers and Employees:
- This includes payments for inventory, operating expenses (like wages), and any other operating costs.
- Cash paid to suppliers and employees = Operating expenses (excluding non-cash items like depreciation) + Changes in accounts payable
Cash Paid for Operating Expenses:
- Operating expenses should exclude depreciation since it is a non-cash charge.
- Cash paid for operating expenses = Operating expenses – Depreciation
Cash Paid for Interest and Taxes:
- You will also need to adjust for interest and taxes paid if they are not already reflected in the operating expenses.
Step 2: Indirect Method – Operating Activities
Under the indirect method, we start with net income and adjust for changes in working capital accounts (current assets and liabilities) and non-cash transactions.
Operating Activities under Indirect Method:
- Start with net income.
- Adjust for non-cash expenses (like depreciation) and gains or losses on asset disposals.
- Adjust for changes in working capital (changes in accounts receivable, accounts payable, inventory, etc.).
Step 3: Preparing the Memo to the President
Memo
To: President
From: [Your Name]
Subject: Explanation of Decrease in Cash Balance for 2010
Dear President,
Despite a profitable year, the company experienced a decline in its cash balance. This situation can be explained by several factors that are important to consider when managing cash flow:
- Investment in Assets:
During the year, the company acquired land and plant and equipment. These investments were paid in cash, which directly impacted the cash balance, despite the profitability from operations. - Dividends Paid:
The declaration and payment of $60,000 in dividends reduced the cash balance further. Dividends represent a distribution of profits but do not improve liquidity. - Depreciation:
Depreciation of $50,000 is a non-cash charge, meaning it reduces net income but does not affect cash. Adjusting for depreciation shows a stronger operating cash flow than the net income alone. - Financing Activities:
Cash was received from additional bank loans and from the issuance of additional stock. These actions increased cash but may not be sustainable sources of cash flow in the long term.
Recommendations:
To improve cash flow in future years, I recommend focusing on:
- Better Working Capital Management: Ensure that cash flows are efficiently managed through reductions in inventory or better collection of accounts receivable.
- Limiting Cash Outflows: Be cautious with asset acquisitions and only make necessary investments. Also, review the policy on dividend payments to balance cash needs with shareholder returns.
This approach will help ensure a stable cash position while maintaining profitability.
Sincerely,
[Your Name]
[Your Position]
This is a general guide for the memo and statement based on the provided information. Let me know if you’d like further details or adjustments!