According to rule-of-thumb in evaluating cash flows, China Trade had a performance below the expectations for the month ended 31st August 2001. Under the rule, cash flows from operating activities are expected to be positive and able to cover the negative cash flows that may result from investing activities. It is anticipated under the rule of thumb of evaluating cash flows that a company will have new investing activities leading to negative cash flows in the category, where the negative figure should be covered by the operating activities cash flows. China Trade, operating cash flows were negative (- $ 3,000) implying that the companys cash flows did not satisfy the first condition of the rule, and, hence also unable to meet the second condition. Therefore, in the light of the rule-of-thumb, China Trades operating cash flows can be adjudged as poor and below par and requires improvement to meet the expectations.
The rule-of-thumb identifies the operating cash flows as an important factor in determining the strength of a company financially. A company with healthy cash flow can easily avoid financial distress issues that arise because of failing to meet obligations when due and attracting debtors and other providers of capital debt scrutiny (Quiry & Vernimmen, 2011, p. 25). As per the rule-of-thumb, first, the operating cash flows of an organization that has strong cash flows should be positive. In meeting this condition, the business should generate cash inflows from the main business activities. When a company generates positive cash flows from primary business activities, it implies that it does not depend on borrowed finances in meeting the investing activities that are expected to generate negative cash flows. The second condition of the rule is the positive cash flows should be more or equal to the negative investing cash flows to ensure that the business finances all investing activities for health financial operations. On the other hand, investing activities are expected to have a negative cash flow when a company is growing and not disposing of its assets since cash inflow in investing activities is an indication of reduction of assets and an outflow implies there is an increase in assets. Therefore, the operating cash flows as per the rule should be positive with a higher absolute figure as compared to the investing activities cash outflows. In a case where the above two conditions of rule-of-thumb are not met, as it is in the China Trade cash flows, the company viewed as having weak cash flow.
China Trade made a profit of $ 300 according to the income statement and had negative operating cash flows of $ 3000 according to the statement of cash flows. Despite the operating cash flows and the statement of income statement being prepared for the operating activities of the business, typically, a difference between the two occurs (Stice & Stice, 2013, p. 10). The causes of difference in the net income and net operating cash flows for China Trade are discussed below.
When a company makes sales, the entire money that is payable may not be paid instantly because sales are made in either cash or credit, hence meaning that some payments are made at a later date depending on the agreement between the business and the customer (Wahlen, Baginski, Bradshaw, & Stickney, 2011, p. 149). During the period the cash flows statement is being prepared, part of the credit sale may not have been paid hence the difference between sales and cash paid by customer arising. For example, China Trade had sales of $ 12, 650 out of which $ 7000 was paid in cash. From the transactions, the company made credit sale of $ 8000, out of which only $ 2000 was paid by 31st August 2001, at the time of preparing the statements. The transaction is part of several other credit sales that leads to the difference between the sales and the cash received.
In the statement of income statement, the cost of goods sold is recorded while in the statement of cash flows, cash paid to the suppliers for inventory bought during the period is recorded. The two entries recognized in the statements can lead to a variance between the balancing figures because they are different. A company can make more purchase of inventory than goods sold in a period with part of the goods remaining in the stock, and hence creating a difference. Also, a company can make a purchase in cash and credit, and once a credit purchase is made, the transaction does not lead to cash outflow and therefore not recorded in the statement of the cash flows though part of the goods may be sold and recorded in the income statement. China Trade had the cost of goods sold at $ 7500 and cash paid for to supplier at $ 6000. The difference between the two may have resulted from part of inventory remaining in the stores and also purchases not paid. For example, a credit purchase amounting to $ 12000 was made on 6th August 2001; by the end of the month, the company had paid only $ 6000. It is the $ 6000, which is recorded in the cash flow statement but the remaining amount is not recorded though part of the good may have been sold.
The expenses of the organization are also recognized in both statements, but the amounts recorded vary from the two statements. The reason for the variance may result from some of the expenses for the period paid at a later date or paid at an earlier time (Warren, Reeve, Duchac, & Warren, 2015, p. 642). For example, China Trade had an expense of $ 1000 for advertisement, but paid $ 1300, which shows s the company, had an outstanding expense or it made a payment for future advertisement expenses. Also, the company paid fewer amounts of cash for rent, telephone and wages expenses than the actual expenses for the period, the reason may have been that they would pay the remaining amount later, or it was already paid. From the income statement, the company has income tax obligation of $ 100, which was not paid for the month ending August 2001, and hence, it was not recorded in the cash flow statement. Other expenses are notional and do involve any cash payment, and therefore they do not affect the cash flow statement, but they are recorded in the income statement for the purpose of getting the net income. For example, depreciation is a notional expense that does not lead to cash outflow because it is an internal expense that is used to estimate the loss in value of the current assets. China Trade had a depreciation of $ 250 that was recognized in the income statement, but was not in the cash flows statement that may have lead to the difference between the net income and the net operating cash flows.
Quiry, P. & Vernimmen, P. (2011). Corporate Finance. Chicester, West Sussex, U.K.: Wiley.
Stice, E. & Stice, J. (2013). Intermediate Financial Accounting. Mason, Ohio: South-Western Cengage Learning.
Wahlen, J., Baginski, S., Bradshaw, M., & Stickney, C. (2011). Financial Reporting, Financial Statement Analysis, and Valuation. Mason, OH: South-Western Cengage Learning.
Warren, C., Reeve, J., Duchac, J., & Warren, C. (2015). Financial and Managerial Accounting. Mason, Ohio: South-Western Cengage Learning.
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