Creative cash flow reporting refers to any and all steps used to create an altered impression of operating cash flow and, in the process, provide a misleading signal of a firm’s sustainable cash-generating ability. Steps employed to misrepresent a firm’s sustainable cash-generating ability may employ reporting flexibility within the boundaries of GAAP. Alternatively, steps may be taken that extend beyond the boundaries of GAAP. Finally, amounts may be reported properly as operating cash flow but do not have the sustainable qualities normally expected of operating cash flow. Clearly the adjective “creative” is used here in a pejorative sense. This post provides some overview [with examples] of how cash flow reported in a creative manner misrepresents sustainable cash flow.The Motivation Behind Creative Cash Flow Reporting
Managers are well aware of the importance placed by analysts, investors, and creditors on operating cash flow. Cash flow is the life-blood of any organization. A boost in operating cash flow, even as total cash flow remains unchanged, communicates enhanced financial performance. Consider, for example, the hypothetical cash flow statements presented in below figure:
Statement 1 Statement 2
Cash provided (used) by operating activities = $(14,000) $ 44,000
Cash (used) by investing activities = (36,000) (66,000)
Cash provided by financing activities = 60,000 32,000
Increase in cash = $ 10,000 $ 10,000
As reported in both statements, cash on hand increased $10 million.
However:
- in Statement 1, the company consumed $14 million in cash from operations. Those operating cash needs together with cash needs for investing activities of $36 million were covered with new financing cash flow in the amount of $60 million.
- In Statement 2, the company generated positive operating cash flow of $44 million.The company invested $66 million in the business and obtained $32 million in new financing to help meet its cash flow needs.
The company represented by Statement 2 is doing a better job of generating what would appear to be sustainable cash flow. That company is apparently investing more heavily and relying less on new financing to support its operating and investing activities.
What we now know, however, is that the company represented by Statement 2 may be no different from the company represented by Statement
1. For example: proceeds from the sale of investments may have been used to boost operating cash flow. Similarly, proceeds from new borrowings may also have been reported as operating cash flow. The net result is the appearance of improved financial performance.
In the absence of careful scrutiny, this apparent improvement in financial performance might have a positive impact on a firm’s share price, its borrowing costs, and the incentive compensation paid its executives:
- Share Price Effects - As expectations for sustainable cash flow are increased, so is the present value of that cash flow stream, boosting share-price prospects. Share prices can be influenced to the extent that managers can increase the perception, and not the reality, that their firm is generating more sustainable cash flow. This point was not lost on the executives at companies such as Dynegy, Inc., and Enron Corp. Their managers went to extraordinary lengths to boost operating cash flow in an effort to increase or maintain their share prices. Executives may also have an incentive to report less volatile cash flows, imparting an impression of lower firm risk. The perception of lower risk could move investors to lower their risk-adjusted discount rates. Lower discount rates would boost the present value of future cash flows and potentially raise share prices.
- Borrowing Cost Effects - Interest and principal on loans are repaid with cash flow. Increases in operating cash flow may translate into perceived improvements in debt-service capacity. The net effect may translate into higher borrowing capacity, lower interest costs, less onerous loan covenants, fewer guarantees, or, possibly, less loan collateral.
- Incentive Compensation Effects - To the extent that steps taken to boost operating cash flow translate into higher share prices, managers compensated with stock options will enjoy increased compensation. Beyond such equity-based arrangements, however, some managers may be paid cash bonuses linked directly to improvements in earnings or in operating cash flow. Consider Tyco International, Ltd., a company that has been accused of artificially boosting operating cash flow. As described below, the company’s bonus plan was based, at least in part, on improvements made in operating cash flow: The cash bonus for the Chief Executive Officer and the Chief Financial Officer has two performance based criteria: (i) increase in earnings before non-recurring items and taxes and (ii) improvement in operating cash flow.
Adjustments for Sustainable Cash Flow
All of the factors highlighted in this section can and do lead to misleading operating cash flow amounts. These factors consist of:
- Using GAAP flexibility in cash flow classification
- Taking actions that extend beyond the boundaries of GAAP
- Benefiting from nonrecurring sources of operating cash flow
- Reporting taxes related to non-operating items as operating cash flow
Reported operating cash flow should be adjusted for all of these items in determining sustainable cash flow.
GAAP Flexibility [Is It Operating or Investing Cash Flow?]
Generally accepted accounting principles are reasonably clear in their definition of operating cash flow. There is, however, considerable flexibility permitted in its calculation. Some firms have demonstrated a willingness to ply this flexibility in an effort to boost amounts reported as operating cash flow. Although such steps raise operating cash flow, they do not increase sustainable cash flow.
Examples of cash flow classified as investing activities include both capital expenditures made to boost future operating cash flows and cash parked in debt and equity securities awaiting future needs. Except for capital expenditures that are included in the calculation of free cash flow, cash provided or used in investing activities is not considered to have the same recurring quality as operating cash flow.
Accordingly, to the extent that creative steps can be taken to boost operating cash inflows by increasing investing cash outflows, an appearance can be communicated of a strengthened cash-generating capability. Two areas for such a cash flow misclassification that are representative of the opportunities afforded by the flexibility found in GAAP are investments classified as trading securities and capitalized operating costs. A third area, acquisitions, can also use investing activities to creatively boost operating cash flow.
Creative Cash Flow #1: Investments Classified as Trading Securities
Investments in debt and equity securities may be classified as held for trading purposes or as available for sale. In addition, because they have fixed maturity dates, a third classification, held to maturity, can also apply to debt securities. As the title suggests, trading securities are held to take advantage of very short-term price swings. Holding periods are very short, at times possibly even less than a day. Debt securities that are classified as held to maturity are investments for which a firm has the intent and ability to hold until maturity. The plan is to collect the debt instrument’s principal amount at maturity. All other investments are classified as available for sale, a default classification that can include both short-term and long-term investment positions.
The classification of investments as trading, held to maturity, or available for sale directly affects the classification of cash flows associated with their purchase or sale. When investments are classified as held to maturity or available for sale, the use of cash in their purchase or the proceeds generated by their sale are classified as cash flow from investing activities. In contrast, cash used to purchase or cash provided by the sale of investments classified as trading securities is reported as operating cash flow.
Rules for classifying investments as trading, held to maturity, or available for sale are malleable. This flexibility provides an opportunity for companies to alter reported operating cash flow. For example, cash flows associated with investments in short-term debt instruments classified as held to maturity would be reported as investing cash flow.
However, changing their classification to trading would result in the same cash flows being classified as operating cash flow.
Financial institutions—companies such as banks, insurance companies, and brokerage firms—routinely trade financial instruments. It is part of what they do. Cash flows associated with this activity are properly included with operating cash flow. However, when nonfinancial companies classify investments as trading securities, cash used to purchase the investments or cash provided by their sale does not fit the operating designation. At a minimum, such cash flows are not sustainable and will stop when an investment portfolio has been liquidated.
Creative Cash Flow #2: Capitalized Operating Costs
Generally accepted accounting principles offer flexibility in deciding whether certain operating costs are capitalized or expensed. A common example is software development costs. Capitalization of additional costs is required once technological feasibility is reached. However, because of the use of judgment in deciding when that benchmark is attained, there is a high degree of variation across companies in the amounts of software costs being capitalized.
When expensed, software development costs reduce net income and operating cash flow. However, capitalized software development costs are reported as disbursements in the investing section of the cash flow statement and do not reduce operating cash flow. Both earnings and operating cash flow are increased.
When a software company reaches a steady state, where the amortization of software development costs capitalized in prior periods is approximately equal to new costs capitalized in the current period, the earnings effect of capitalization approaches zero. At this point analysts need not be as concerned about the effects on earnings of the company’s capitalization policy. However, even then amounts capitalized continue to be reported as investing uses of cash. Thus, even when there is no earnings effect, capitalization has a cash flow effect, boosting operating cash flow for new amounts capitalized.
The effects of capitalization on operating cash flow are especially apparent when a company changes its capitalization policy.
During 2001, American Software cut in half the percentage of software costs capitalized from approximately 50 percent in 1999 and 2000 to approximately 25 percent. As a result, a larger proportion of software costs incurred were accounted for as direct reductions in operating cash flow, contributing to its decline, even as software development costs incurred were reduced.
Creative Cash Flow #3: Acquisitions and Operating Cash Flow
When one company acquires another, operating results for the acquired company from the date of acquisition are included with reported amounts for the acquiring company. Thus, an acquisition can serve to boost both reported earnings and operating cash flow. However, beyond these more obvious effects of an acquisition on operating results, there is a lesser-known impact that provides a nonrecurring boost to operating cash flow.
The accumulation through operations of working capital accounts such as accounts receivable, inventory, and prepaid expenses, less accounts payable and accrued expenses payable, serves to reduce operating cash flow. Operating cash flow is increased when these working capital accounts are liquidated.
When working capital is acquired in an acquisition, its cost is reported as an investing and not as an operating use of cash. However, the subsequent liquidation of working capital, even when acquired through an earlier business acquisition, is reported as an operating source of cash. In effect, through an acquisition a company can “acquire” operating cash flow.
Investing activities that can be used to boost operating cash flow within the boundaries of GAAP include short-term investments classified as trading activities, capitalized operating costs, and acquisitions. Financing cash flow includes amounts borrowed and raised through the issuance of capital stock as well as debt repayments, stock buybacks, and dividends. Like cash flow reported in investing activities, financing cash flow is not considered to have the same sustainable qualities as operating cash flow. Flexibility in GAAP can be used to boost operating cash flow that is offset by uses of cash in the financing section.
Xerox’s use of transactions to securitize its finance receivables is another example where cash flow that is ostensibly related to financing transactions is reported as operating cash flow. According to GAAP, proceeds from an outright sale of receivables are reported as operating cash flow. However, when receivables are pledged as security for a loan, any proceeds received are reported as financing activities. The substance of the difference between securitization and pledging transactions is not that great.
Creative Cash Flow #4: Increased Vendor Financing
Vendor financing is a form of financing that, in accordance with GAAP, is properly reported as operating cash flow. Consider the cash flow results for Home Depot, Inc. During the company’s fiscal year ended February 3, 2002, operating cash flow increased to $6.0 billion from $2.8 billion during the previous year. Then during its fiscal year ended February 2, 2003, reported operating cash flow remained strong at $4.8 billion. However, contributing significantly to operating cash flow during both years was an outsized increase in accounts payable.
Increases in the length of time taken to settle accounts payable, a vendor financing of sorts, can be an effective corporate finance tool for managing working capital. However, incremental sources of cash generated in this manner are not sustainable.
Overdrafts classified as operating cash flow, securitized accounts receivable, and extended vendor payment terms are three examples of financing-related activities that ply the flexibility of GAAP to boost operating cash flow. More details of these and other similar actions are provided in Chapter 4.
Beyond the Boundaries of GAAP
Some companies move beyond the boundaries of GAAP, reporting as operating cash flow amounts that are clearly nonoperating in nature. In the case of Dynegy, Inc., mentioned earlier, a complex long-term purchase contract for natural gas was used to gain access to $300 million in financing from Citigroup, Inc. The proceeds from that financing, which were borrowed across 9 months and were to be repaid over 51 months, were reported as operating cash flow.
There are many other examples of steps taken by companies beyond the boundaries of GAAP that artificially boost cash flow. Some involve a misclassification between the operating and investing sections of the cash flow statement. Others, like Dynegy, Inc., involve a financing cash flow reported as cash provided by operating activities.
When taken to extremes, many of the same actions that might be viewed as plying the flexibility of GAAP in the classification of cash flow are considered to have moved beyond the boundaries of GAAP. A restatement made to correct prior-period errors in cash flow classification is compelling evidence of a GAAP-boundary violation. Such a restatement may or may not be in response to alleged fraudulent conduct.
Creative Cash Flow #5: Capitalized Operating Costs
There are numerous examples of companies breaking GAAP rules through their overzealous capitalization of operating costs. In these instances, firms not only boost reported income incorrectly, but operating cash flow also is increased in error. The increase in operating cash flow occurs because amounts expended are reported as investing and not operating uses of cash.
Dynegy’s use of loan proceeds to boost operating cash flow through its long-term natural gas supply contract with a special purpose entity is an excellent example of misreporting financing cash flow as cash provided by operating activities. Enron Corp. entered into similar transactions, also with Citigroup, Inc., and used financing proceeds to boost operating cash flow. The Securities and Exchange Commission forced Dynegy to restate its cash flow statement. At the time of this writing, a restatement of Enron’s financial statements is pending.
Creative Cash Flow #6: Nonrecurring Operating Cash Flow
Even when companies maintain their financial statements within the boundaries of GAAP and do not employ flexibility in the rules to boost operating cash flow, amounts may be reported as operating cash flow that are nonrecurring. In such instances operating sources of cash do not provide the sustainable supply of cash that is normally expected of operations.
For example: a cash collection resulting from a one-time litigation settlement may be included with operating cash flow. Similarly, operating cash payments associated with restructuring events are, in most instances, nonrecurring uses of cash. There are many other examples of nonrecurring operating cash flow.
Misleading Cash Flow Classifications under GAAP
Collectively, all steps taken to misrepresent the sustainable nature of operating cash flow are referred to here as creative cash flow reporting. Those steps may be taken within the boundaries of GAAP or beyond those boundaries, or may be the result of nonrecurring sources of operating cash flow. Each of them results in operating cash flow that is not sustainable.
Beyond what is referred to as creative cash flow reporting, there are specific items, especially in the cash flow classification of income taxes, where GAAP state clearly that non-operating items should be included in operating cash flow. Such items may add to or subtract from operating cash flow and create misleading amounts. Taxes and Operating Cash Flow All transactions that result in income or expense, gains or losses, have income tax implications.
According to GAAP, except for one proposed exception, the cash disbursements or receipts related to all such taxes are reported with operating cash flow. An operating designation was chosen because of the complexity and arbitrary nature of allocating taxes to operating, investing, and financing classifications depending on the nature of the underlying item.
When taxes relate to income or expense items included in operations, those taxes should be included in the calculation of operating cash flow. It is a proper grouping of like items. However, when taxes relate to investing or financing items, their inclusion in operating cash flow clouds that measure.
Taxes and Investment-Related Gains
For example: on November 15, 2001, Bristol- Myers Squibb Co. sold its Clairol business to Procter & Gamble Co. for approximately $5.0 billion in cash. As a result of the sale the company recorded a pretax gain of $4.2 billion.
Taxes due on the sale totaled $1.7 billion. Bristol-Myers reported the full pretax proceeds from sale, $5.0 billion, in the investing section of its cash flow statement. Taxes due on the sale were deducted from operating cash flow when paid in early 2002. In fact, due primarily to a cash drain resulting from the payment of taxes on the Clairol gain, the company reported negative operating cash flow of $1.1 billion in the first quarter of 2002.
That was down considerably from the positive operating cash flow of $900 million generated during the same period of the previous year. Tax Benefits from Stock Options The exercise of stock options generates a financing source of cash equal to the exercise price on the underlying options. Option holders pay the company an amount equal to the exercise price times the number of options being exercised.
To the company, this is cash received for the sale of stock. It is a financing source of cash and is reported as such on the cash flow statement. When the holders of nonqualified options, typically company officers and employees, exercise their options, the company receives a tax deduction equal to the difference between each option’s exercise price and the market price of the underlying stock times the number of options exercised. The option-related tax deduction can be quite substantial and provide tax benefits, a source of cash, which can run into the hundreds of millions or even billions of dollars.
Consistent with the treatment of taxes generally, tax benefits from stock options are reported as operating cash flow. However, because the sale of stock that gave rise to the tax benefits is a financing event, its related tax benefits are not truly part of operations.
Historically, Microsoft Corp. reported tax benefits from stock options as a financing source of cash. However, Emerging Issues Task Force (EITF) Statement No. 00-15 clarified the cash flow classification of tax benefits from stock options forcing the company to restate its cash flow statements.33 In the restatement, tax benefits from stock options were reclassified to the operating section.
Recently, the FASB proposed that tax benefits received arising from tax deductions related to the exercise of nonqualified stock options that exceed the amount of option-related compensation expense reported on the income statement should be classified as financing cash flow. Such a change in classification would be more in keeping with the financing nature of such tax benefits.
Cash flow forecast
If there is no chief financial officer (CFO) or treasurer, then the job of determining the projected flow of cash falls on the shoulders of the controller or even an accountant for small-medium enterprises. This means that the controller or the accountant must maintain a worksheet that estimates the cash inflows and outflows, perhaps as frequently as on a weekly or even daily basis, so that management can tell when there will be a need for either extra financing to obtain cash or extra investing for excess cash.
This post DOES NOT ONLY provides guideline on how to create cash forecast, but it reveals some facts that a controller found during the process of the cash forecast construction, potential issues and how to deal with the issues to keep your cash forecast the most valuable tools for financial decision-making. Consequently, this post become longer than any other cash forecast construction guideline ever published in the internet. It is dedicated to the people who have been engaged in the real financial world, but financial observers and students should find it useful too.
The basic concept on which the cash forecast is built is that this is not accrual accounting—we do not care about accrued revenues or expenses, just actual receipts or payments, from and to all possible sources. For example, if the accrual system is gradually recording an annual property tax payment of $120,000 in monthly $10,000 installments, these installments will not appear in the cash budget, because there is no actual monthly payment. Instead, there will be a single annual cash expenditure of $120,000 that will appear in the forecast when the full amount is due for payment.
The cash forecast format constructed in this post is split into three pieces: one for assumptions, another for cash inflows, and the final piece for cash outflows. In the first section of the budget, as shown in below figure, the underlying data and assumptions needed to compile the remainder of the report are listed. Here is an example of Cash Forecast:
Cash Flow Line Item January February March
Section I—Assumptions
Sales dollars per period $2,000,000 $2,500,000 $3,000,000
Production costs as a-
percentage of sales 50% 55% 55%
Days needed to collect-
accounts receivable 45 45 45
Days needed to pay-
accounts payable 30 30 30
Days of inventory on hand 60 60 60
Sales tax percentage 6% 6% 6%
Sales per employee $100,000 $100,000 $100,000
Annual average pay per employee $40,000 $41,000 $41,500
Section II—Cash Inflows
Collections on
accounts receivable* $2,000,000 $2,000,000 $2,250,000
Collections on notes receivable 5,000 5,000 2,500
Collections from asset sales 0 15,000 0
Collections from equity sales 0 0 100,000
Total Cash Inflows $2,005,000 $2,020,000 $2,352,500
Section III—Cash Outflows
Payments for production costs* $1,000,000 $1,100,000 $1,375,000
Payments for salaries and wages 66,667 85,417 103,750
Payments for general and
administrative costs 175,000 175,000 175,000
Payments for capital expenditures 0 150,000 0
Payments for notes payable 25,000 25,000 25,000
Payments for sales taxes 120,000 150,000 180,000
Payments for income taxes 0 0 75,000
Payments for dividends 0 200,000
Incremental inventory change 0 750,000 550,000
Total Cash Outflows $1,386,667 $2,435,417 $2,683,750
Net Cash Flows +618,333 -415,417 -331,250
Cumulative Net Cash Flows +$618,333 $202,916 -$128,334
* Sales for each of the two preceding months are assumed to be $2,000,000.
Section I — Assumptions
- Sales dollars per period. The key driver of the entire cash forecast is the amount of sales volume to be expected in each of the measurement periods. This is because the sales figure interacts with the amount of purchases and days of inventory and accounts receivable that are expected to be on hand; and all three of these items are major components of the cash outflow portion of the cash forecast.
- Production costs as a percentage of sales. The amount of production costs needed in each period is derived directly from the anticipated sales figure for each reporting period. The controller usually uses historical actual results from the financial statements to determine the percentage of purchases that occur for each dollar of sales. This is typically a reliably steady and easily predicted figure.
- Days needed to collect accounts receivable. This assumption interacts with the sales figure from previous months to arrive at the amount of collections from accounts receivable expected in the current month. For example, if an average of 30 days are needed to collect funds, then the entire sales figure from the immediately preceding month can be listed as cash received in the current month. However, if the collection period is 60 days, then the entire sales figure from two months ago can be predicted as cash received in the current month.
- Days needed to pay accounts payable. When determining cash outflows, the primary determinant is the average number of days during which a company holds onto its accounts payable before issuing payment to suppliers. This figure can vary over time as the mix of suppliers (who may have differing payment terms) changes, or is based on decisions by management to lengthen payment terms if there will be anticipated cash shortages.
- Days of inventory on hand. A major element of working capital that has a strong impact on cash flows is the days of inventory that management chooses to keep on hand. This is not a steady turnover figure, especially for companies with a wide array of new products, because new inventory must be added to support new products. This item in particular is deserving of careful attention to ensure that the correct turnover figure is used.
- Sales tax percentage. This is the percentage that the company owes the government on sales that occurred in the prior period. This percentage is then multiplied by the sales projection for the preceding period to derive the total sales tax payment for the current month.
- Sales per employee. A component of the cash outflow section at the bottom of the cash forecast is the payroll cost, which is partially derived by this line item, which assumes a certain headcount based on the sales volume. This figure must be used with care, because some employees in the overhead category will be on the payroll even if there are no sales. Consequently, a more detailed cash forecast might also include the number of overhead employees based on the budget, rather than tying all personnel to sales volume.
- Average pay per employee. The preceding measure determines the number of employees who will be paid in the payroll expense that is noted under the cash outflows section of the cash forecast report, while this measure multiplies the total headcount by the average pay per person to determine the actual cash outflow.
Section II — Cash Inflows
- In the second section of the cash forecast shown, all possible sources of cash inflows are included. The primary one by far is collections on accounts receivable, though there are three additional line items for other sorts of discretionary cash inflows. Because these last three are not based on continuing operations and are not driven by formulas from the first section of the cash forecast, they are highlighted with italics, which denotes manual entries in the model. Descriptions of the line items are:
- Collections on accounts receivable. This is the primary source of cash inflows, and the only one from continuing operations. It is created by a formula that determines the amount of cash receipts that can be expected from the sales in previous months. The inputs are the “sales dollars per period” and “days needed to collect accounts receivable” line items in the first section of the cash forecast.
- Collections on notes receivable. A relatively minor item in most cases is the receipt of cash in payment for funds that the company has lent out to employees or other organizations. This is usually a manual entry in the cash forecast.
- Collections from asset sales. A company will sell assets from time to time, which results in a cash inflow. Because the exact period or amount of sale is rarely predictable, this cannot be included in the assumptions section and is a manual entry in the cash forecast.
- Collections from equity sales. Another source of funds is the sale of equity. This is done at the company’s discretion and is usually timed to take advantage of the highest possible market price of company stock. Due to the timing problems associated with market conditions, this is not a predictable item that can be included in the assumptions section and is thus a manual entry in the cash forecast.
Section III — Cash Outflows
In the final section in the figure, all possible sources of cash outflows are included. There are a number of major contributors to this category [as opposed to the single one—collections from accounts receivable—that was the case for cash inflows]. The most important ones (in descending order) are payments for production costs, payroll, general and administrative payments, capital expenditures, and notes payable. These final two items may be switched in priority for highly leveraged companies that make large debt payments. Several items in this section are not based on continuing operations or derived from formulas in the first section of the cash forecast, so they are highlighted with italics, which denotes manual entries in the forecasting model. Descriptions of the line items are:
- Payments for production costs. These are the costs for materials and associated production supplies that are needed to create products. In essence, this is the cost of goods sold, not including direct labor costs. This is typically the largest cash outflow for most companies, with the exception of service industries.
- Payments for salaries and wages. This is usually the second largest cash outflow, save for companies located in services industries, in which it is the largest. In Exhibit 5.2, this cash outflow is derived with a formula that is based on the sales per employee and the average pay per person. However, this formulation assumes that headcount varies directly with the sales level, which may not be the case. An alternative approach is to use the payroll listed in the budget.
- Payments for general and administrative costs. These costs are associated with corporate overhead, such as sales, audits, insurance, and rent. The best source of this information is the budget, because it rarely varies with the estimated sales level.
- Payments for capital expenditures. Payments for capital expenditures are highly predictable, because they are already listed in the budget and can be determined with some additional precision, since the expenditure authorizations normally come through the accounting department well in advance of any purchase.
- Payments for notes payable. Debt payments can be derived from a separate schedule of loan payment dates and amounts. There is no need to separate the interest expense and principal into two separate line items, because the concern here is only with the amount of the cash outflow, and not the exact nature of the outflow.
- Payments for sales taxes. Sales taxes can be predicted based on a percentage of the estimated sales. Accordingly, the formula for this is a combination of the estimated sales from the preceding month and the sales tax percentage.
- Payments for income taxes. It is difficult to reevaluate the entire budget in order to arrive at an estimate of the net income for the next few periods, so an easier approach is to use the estimated net income tax already located in the budget, adjust for any obvious expected changes in income, and record this expense in the cash forecast as a quarterly payment.
- Payments for dividends. Dividends are very predictable, because the board of directors specifies the amount to be paid, usually well in advance of the actual payment, and also because most companies maintain such a consistent level of dividend payments that the amount to be paid is probably very consistent with previous payment amounts.
- Incremental inventory change. Projected changes in inventory can be an important reason for both cash inflows and outflows. This is the only line item in the cash outflows section that can show either an inflow or an outflow, because inventory levels may rise or fall. This item is derived from a formula that alters the inventory level based on the assumed number of days of inventory shown in the assumptions section of the cash forecast.
Having described the components of the cash forecast in some detail, the information can now be assembled into a coherent forecasting model, as shown in the above figure. In the example, the forecast is limited to three monthly reporting periods. The model could include the previous two periods, because the collections and payments information is based on sales information from previous periods. However, adding historical information can be confusing to the reader, so it will be assumed that this information is located in hidden columns that are not included in the final report. Next, all relevant assumptions are included. Sales are expected to increase through the reported periods, with an increase in the cost of production as a proportion of sales; these are the first two items in the cash forecast, because they have the largest impact on the forecast result.
Then the two cash delaying factors are included, which are the standard number of days that will pass before a company can expect to receive cash in payment for previous sales, as well as to make payments for previous purchases. The next item, the days of inventory on hand, is used later in the cash outflows section to determine the amount of inventory that must be maintained to support the current sales level. A sophisticated cash forecasting model might include a provision for inventory to be built up in advance of sales, so that there would be an associated cash outflow some time in advance of sales being generated, because customers will not purchase products unless there is first a stock of inventory on hand from which to purchase. The next two line items, the sales per employee and the average pay per employee, are used later in the cash outflows section of the model to arrive at the payroll cost.
In the second section of the forecast, all cash inflows are shown. The collections on accounts receivable are based on a collection period of 45 days, as was noted under the assumptions in the first section of the forecast. For the months of January and February, collections are drawn in part from preceding months that are not shown in this forecast; it will be assumed that the amount of sales in all previous months is $2 million [as is also stated in the note at the bottom of the figure]. Because the sales in previous months are all the same, the collections will also be $2 million per month for the first two months. However, the collections figure for March shows a different amount. The collections total of $2,250,000 is based on a 45-day collection period for months that have different sales totals; in this case, one half of the sales are drawn from January sales and one half from February. Going forward, the same calculation will apply in April, which will include one half of the sales from February and one half from March. The remaining items in the cash outflows section are manually entered, because they are not based on continuing operations and therefore cannot be automatically forecasted.
In the third and final part of the cash forecast, the amount of payments for production costs is calculated by taking the total sales figure for the preceding month [since one of the assumptions in the first section is a time lag on payments of 30 days] and multiplying it by the percentage of production costs, which was also noted in the assumptions section. The salaries and wages payment is calculated by multiplying the sales level for the month by the sales per person (which assumes that headcount varies directly with sales volume), and is then multiplied by the average pay rate, which must then be divided by 12 to determine the monthly salary total. The general and administrative expense is taken from the budget, as are the cash flows shown in the following line items for capital expenditures, notes payable, and income taxes. The payment for sales taxes is derived by multiplying the projected sales for each month by the sales tax per dollar of sales. A sophisticated model could include a time-lag feature for the sales tax payment, since remittances to the various governments require a varying number of days delay before payment is due.
Finally, the incremental inventory change is calculated by multiplying the percentage of production costs [as noted in the assumptions section] by the sales dollars for the period, which gives us the materials portion of the cost of goods sold. Then, the days of inventory on hand is taken into account, which is 60 days for all three forecasted periods; this translates into having enough inventory on hand to cover the materials portion of the cost of goods sold for two months. Sales are projected to increase substantially for the second two months of the report, so the inventory will correspondingly increase. This turns out to be a very substantial cash amount, because the inventory level required to support sales is considerable.
The last steps are to summarize the cash outflows sections and subtract them from the totals for the cash inflows sections. The last row of the report shows the cumulative cash flow for all reported periods. The cumulative figure is of most use for determining any borrowing or investing needs in the near term. In the example, the increase in sales has sparked a significant increase in the amount of cash needed for inventory, which offsets cash inflows from the increased sales. As a result of the revenue surge, there is less cash than at the beginning of the reporting period.
A generally minor issue in a cash forecast is cash inflows and outflows that are not based on credit. For example, customers may pay for their purchases immediately in cash, as may the company to its suppliers.
Most organizations conduct their business almost entirely on credit, which leaves cash transactions as a vanishingly small portion of the total of all cash inflows and outflows. Thus, it is generally safe to exclude cash transactions from the cash forecasting model. The main exception to this rule is those industries, such as retail food distribution, in which nearly all sales transactions are paid in cash. In these situations, the cash inflows must be divided into cash from sales, with a lag of zero days, and all other sales (probably in the form of credit cards or checks), for which there is a short delay of perhaps 7 to 10 days. This arrangement should be sufficient for those situations in which cash inflows are the norm.
A key issue in the preparation and distribution of the cash forecast is that it must be as accurate as possible—the controller should not just mechanically prepare it based on old assumptions from months before. On the contrary, many of the underlying assumptions that are listed in the first part of the cash budget will change over time and must be updated regularly to ensure the highest possible degree of accuracy in the forecast. If this updating function is not performed, then the cash forecasts will not be as accurate, which will lead to a loss of confidence by users in the report; eventually, it may even fall into disuse if the information it imparts is sufficiently inaccurate.
To determine the level of accuracy, it may be useful to retain the last few reporting periods on the report and, for those periods, report the actual cash balance next to the projected balance, with a percentage difference.
This extra information reveals the level of accuracy of the reported information. If the cash forecast is continually inaccurate, one should investigate the underlying causes. For example, there may be a small group of customers who habitually pay later than all other ones. If so, it may be necessary to divide projected sales into two categories, one for those customers and one for all others, and assume different collection periods for each group. Similar levels of detailed refinement may be necessary in other areas as well. If this results in an excessively lengthy cash forecast that is difficult to update, then a controller must weigh the utility of having more accurate information against the work required to obtain it. There is usually some median level of reporting accuracy that is sufficient for a company’s practical needs, and this is the point at which no further cash forecast revision work is necessary.
What to do when investment accounts is increasing?
Increasing on investment accounts are obviously symptoms that a controller [financial managers or even CFO] should react immediately. It indicates the presence of a multitude of potential illnesses on the company’s financial performance. Such symptoms are ones that a typical controller, armed with an adequate financial reporting system, can spot with a cursory review of the financial statements. In this post, I noted the investment accounts [i.e.; Accounts Receivable, Inventory and Fixed Asset] symptoms, and then describe the forms of financial analysis one should undertake in order to precisely determine the nature of the illness, followed by brief descriptions of possible solutions.
However, each level of analysis recommended in this post requires much more time to complete, so one should expect the most thorough analysis to require days or weeks of effort. When it looks as though the analysis work will be substantial, a controller should always consider two options:
- Option#1. Immediately stop further analysis work as soon as preliminary analysis results indicate that the underlying problem has probably been found, so that corrective action can be taken as soon as possible. After all, a highly detailed proof of the problem, accompanied by a tastefully packaged analysis and presentation, does not do much good if a terse e-mail summarizing preliminary results could have warned the management team a week sooner.
- Option#2. Construct new financial reporting systems that quickly and accurately collect and summarize much of the financial analysis work that was previously completed by hand, thereby saving large amounts of time. This second approach can be very expensive if a controller is determined to build reporting systems to spot every conceivable problem area.
A combination of both approaches allows a controller to rapidly determine problem areas and disseminate information to management about not only the problem, but also suggested solutions.
The Investment In Accounts Receivable Is Increasing
What to do? Here are what to do:
Check the turnover trend. The first step is to see if the increase in accounts receivable is based on an increase in sales volume. For example, if a customer has purchased far more than the usual amount recently, the company will be funding the customer for the amount of this purchase until the contractually agreed-upon payment date has been reached. Consequently, to determine if the accounts receivable turnover rate has changed, run a trend line for this measure for at least the last quarter by dividing accounts receivable into the annualized sales for each month being measured.
Controller’s recommendation: Review sales to see if the increase in sales will continue. If so, arrange for more debt funding to cover the projected increase in accounts receivable.
Check turnover trend by customer. If the accounts receivable turnover trend is worsening, the next step is to determine which customers are not paying on time. This can be done either by calculating the turnover trend for each customer or by skimming through the accounts receivable aging to see which customers have large overdue balances.
Controller’s recommendation: If a specific customer is not paying on time, then possible remedies range from a visit to the customer to discuss payment terms, to cutting off additional credit, reducing the preset credit limit, or even filing a lawsuit to collect funds.
Check the credit granting process. If a customer is clearly unable to pay for goods received, an additional question is how did the customer ever receive credit terms sufficient to allow for significant bad debt to accumulate? This calls for a review of the credit granting process to ensure that credit checks are conducted and credit limits approved by authorized personnel.
Controller’s recommendation: Besides the corrective actions just noted, the management team should ensure that credit reviews for existing customers are done at regular intervals, to ensure that changes in the financial condition of customers are spotted in a timely manner and credit terms changed to match the new financial situation.
Review for fraud. If there is some difficulty in contacting the customer, or if further review reveals that the customer no longer exists, there may be some chance of a fraudulent situation where the customer never had any intention of paying for the goods or services delivered.
Controller’s recommendation: Not only should there be a detailed review of the credit granting process to ensure that newly incorporated customers are especially carefully screened, but also that there is no linkage between employees granting credit and the customers who have fraudulently taken delivery of company goods or services.
The Investment In Inventory Is Increasing
What to do? Here are what to do:
Check the turnover trend. If sales are increasing, then the amount of inventory needed to support those sales may be justified. To verify if this is the case, calculate a trend line for inventory turnover for at least the last quarter of a year. To do so, divide the current inventory balance into the annualized cost of goods sold. If the turnover proportion has dropped, then there is proportionally more inventory on hand than is justified by the increase in sales.
Controller’s recommendation: Review the cause of any increase in sales to see if the increase is projected to continue. If so, the increased inventory level is unlikely to decline, and additional funding will be necessary to support the added inventory investment.
Review the last date on which inventory was used. If inventory turns have worsened, then one possible problem is that some of the inventory is obsolete. One way to check this is to review the dates when inventory was last used. One approach is to see if there is such a date tracked by the computer system, or if there are dated inventory tags on the inventory items or dated shipping labels on the inventory. Then, compile the dollar value of all items that have not been used in some time to determine the level of obsolescence.
Controller’s recommendation: Institute a periodic inventory liquidation procedure, so that all old inventory items are regularly reviewed and sold off.
Verify where parts are used. Another way to determine inventory obsolescence is to see where parts are being used. The best way is to use the “where used” feature that is common in most manufacturing computer systems, allowing one to enter a part number and have the system feed back information about the products in which those parts are used. If there are no products in which they are used, the parts are clearly obsolete.
Controller’s recommendation: There must be a reason why parts are in stock, even though there are no products in which they are used. The usual reason is that the engineering staff has changed to a new part without first using up the old stock of parts. Accordingly, one action for management is to review the unused parts to see if they can still be used in the newer, revised products, and secondly, to set up a procedure so that the engineering staff is forced to use up existing inventories before switching to a new part.
Review the sales trend for all finished goods kept in stock. If it is evident that the bulk of the inventory is in finished goods, one should verify the sales trends for all products for which there is some inventory. If sales trends are declining and the amount of on-hand inventories are high, there may be a problem liquidating the inventory.
Controller’s recommendation: Set up a procedure with the production scheduling staff to ensure that additional production is not scheduled for any item that is experiencing a drop in sales. Also, have the sales staff run a promotion or temporary price decrease to clear out all excess finished goods inventories for products that are experiencing slow sales volume.
Review the turnover for work-in-process inventories. If there are no problems with either raw materials or finished goods inventories, we are left with work-in-process (WIP) inventory. See if the inventory turnover level for WIP has changed significantly over the last few months by creating a trend line for WIP inventory turnover (calculated by dividing the current WIP inventory total by the annualized cost of goods sold).
Controller’s recommendation: See if there are any partial assemblies that have not been completed for lack of parts or machine capacity, and finish them. Also, verify that there is not an excessive quantity of WIP kept in a quality hold area for repair work. Also, verify that WIP is not piling up in front of a bottleneck operation; if there is, either cut back on the production coming from upstream work centers, or increase the capacity of the bottleneck operation. Finally, see if WIP is being held up at off-site locations or suppliers for finishing work; if so, expedite all such completion activity.
Verify the size of purchased quantities. It is possible that the purchasing department is trying to obtain low per-unit costs by purchasing in excessively large quantities. If so, there will be very large on-hand quantities of selected parts.
Controller’s recommendation: Have the purchasing staff review the cost of buying in smaller multiples, and buy in this manner if there is a reasonable cost-benefit tradeoff. If not, then buy in large multiples, but issue releases from the suppliers’ stock in weekly or smaller increments, so that the company is paying for only a portion of the total purchase at one time.
Look for costing errors. If there is no evident change in the quantities of any inventories, it is possible that the per-unit cost has been accidentally changed in the inventory database. If so, compare the per unit cost of each item for the current period and for the same items in a previous period. If there are significant differences, review the reasons for the costing changes.
Controller’s recommendation. Lock down the inventory costing database so that only authorized personnel are allowed to make changes. Also, audit the more expensive material costs to ensure that costs are accurate. Further, restrict access to the unit of measure field in the inventory database; for example, if the unit of measure for a roll of tape costing $1.00 per roll is changed to inches (with 1,760 inches on the roll), the cost of the roll will suddenly increase from $1 to $1,760.
The Investment In Fixed Assets Is Increasing
What to do? Here are what to do:
Compare assets purchased to the original budget. There may be nothing wrong with a rapid increase in the asset base, as long as the additions were purchased in accordance with the original fixed asset budget. Simply compare all purchases to the original budget, and verify that all authorizations are in place for everything purchased.
Controller’s recommendation: Institute a tight capital budgeting procedure to ensure that no assets are purchased that have not gone through the entire budget approval process. Also, verify that capital approval levels are low enough to ensure that the correct managers are affixing their signatures to the purchase orders for the bulk of the dollar volume spent on fixed assets.
See if the depreciation method has changed. If someone has inadvertently altered the depreciation method being used, this can result in a significant change in the net value of all fixed assets. Review the fixed asset register to ensure that the same depreciation method is being used for all items within each fixed asset category.
Controller’s recommendation. Create an internal audit procedure for checking the depreciation method used for a sample of all fixed assets in the assets register.
Verify that asset values are removed from the books when disposed of. Some companies have such poor accounting systems that there is no record of asset removals once they have been sold or otherwise disposed of. If so, the asset value on the books will be excessively high. To verify this problem, conduct an audit of the fixed assets and compare all items found to those listed on the accounting books.
Controller’s recommendation: Institute a procedure for properly removing all assets from the books of record once they have been disposed of. Also, institute a policy of conducting a fixed asset audit at fixed intervals that is designed to spot any asset dispositions that have not been properly recorded.
Verify that only assets exceeding the capitalization limit are capitalized. It is possible that asset values are increasing because the accounting staff is incorrectly capitalizing assets that are too low in cost, and which should actually be expensed. Sample the fixed-asset register and verify that all recorded assets exceed the capitalization limit.
Controller’s recommendation: Implement additional training of the accounting staff to ensure that they do not capitalize items that are below the capitalization limit.
What to do when the revenue [sales] account is declining? What to do when funding supplied by accounts payable is shrinking? What to do when some costs and expenses is increasing? What todo when return on equity [ROE] is going worst? There are many more symptoms that financial managers, controllers and CFOs should aware and taken care immediately. I will keep posting such symptoms and solutions going forward. If you love those topics, you may want to keep watching and check into this blog often.
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