Understanding Business Accounting For Dummies, 2nd Edition (51 page)

Debtors increase

Remember that the debtors asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, debtors is the amount of uncollected sales revenue at the end of the period. Cash does not increase until the business collects money from its customers.

But the amount in debtors
is
included in the total sales revenue of the period - after all, you did make the sales, even if you haven't been paid yet. Obviously, then, you can't look at sales revenue as being equal to the amount of cash that the business received during the period.

To calculate the actual cash flow from sales, you need to subtract from sales revenue the amount of credit sales that you did not collect in cash over the period - but you add in the amount of cash that you collected during the period just ended for credit sales that you made in the
preceding
period. Take a look at the following equation for the business example, which is first introduced in Chapter 6 - the income statement figures used here are given in Figure 6-2, and the asset and liability changes are shown in Figure 7-1. (No need to look back to Figure 6-2 unless you want to review the income statement.)

£25 million sales revenue - £0.8 million increase in debtors = £24.2 million cash collected from customers during the year


The business started the year with £1.7 million in debtors and ended the year with £2.5 million in debtors. The beginning balance was collected during the year but at the end of the year the ending balance had not been collected. Thus the
net
effect is a shortfall in cash inflow of £800,000, which is why it's called a negative cash flow factor. The key point is that you need to keep an eye on the increase or decrease in debtors from the beginning of the period to the end of the period.

If the amount of credit sales you made during the period is greater than the amount collected from customers during the same period, your debtors
increased
over the period. Therefore you need to
subtract
from sales revenue that difference between start-of-period debtors and end-of-period debtors. In short, an increase in debtors hurts cash flow by the amount of the increase.

If the amount you collected from customers during the period is greater than the credit sales you made during the period, your debtors
decreased
over the period. In this case you need to
add
to sales revenue that difference between start-of-period debtors and end-of-period debtors. In short, a decrease in debtors helps cash flow by the amount of the decrease.

In the example we've been using, debtors increased £800,000. Cash collections from sales were £800,000 less than sales revenue. Ouch! The business increased its sales substantially over last period, so you shouldn't be surprised that its debtors increased. The higher sales revenue was good for profit but bad for cash flow from profit.

An occasional hiccup in cash flow is the price of growth - managers and investors need to understand this point. Increasing sales without increasing debtors is a happy situation for cash flow, but in the real world you can't have one increase without the other (except in very unusual circumstances).

Stock increase

Stock is the next asset in Figure 7-1 - and usually the largest short-term, or
current,
asset for businesses that sell products. If the stock account is greater at the end of the period than at the start of the period - because either unit costs increased or the quantity of products increased - what the business actually paid out in cash for stock purchases (or manufacturing products) is more than the business recorded as its cost-of-goods-sold expense in the period. Therefore, you need to deduct the stock increase from net income when determining cash flow from profit.

In the example, stock increased £975,000 from start-of-period to end-of-period. In other words, this business replaced the products that it sold during the period
and
increased its stock by £975,000. The easiest way to understand the effect of this increase on cash flow is to pretend that the business paid for all its stock purchases in cash immediately upon receiving them. The stock on hand at the start of the period had already been paid for
last
period, so that cost does not affect this period's cash flow. Those products were sold during the period and involved no further cash payment by the business. But the business did pay cash
this
period for the products that were in stock at the end of the period.

In other words, if the business had bought just enough new stock (at the same cost that it paid out last period) to replace the stock that it sold during the period, the actual cash outlay for its purchases would equal the cost-of-goods-sold expense reported in its income statement. Ending stock would equal the beginning stock; the two stock costs would cancel each other out and thus would have a zero effect on cash flow. But this hypothetical scenario doesn't fit the example because the company increased its sales substantially over the last period.

To support the higher sales level, the business needed to increase its stock level. So the business bought £975,000 more in products than it sold during the period - and it had to come up with the cash to pay for this stock increase. Basically, the business wrote cheques amounting to £975,000 more than its cost-of-goods-sold expense for the period. This step-up in its stock level was necessary to support the higher sales level, which increased profit - even though cash flow took a hit.

It's that accrual basis accounting thing again: The cost that a business pays
this
period for
next
period's stock is reflected in this period's cash flow but isn't recorded until next period's income statement (when the products are actually sold). So if a business paid more
this
period for
next
period's stock than it paid
last
period for
this
period's stock, you can see how the additional expense would adversely affect cash flow but would not be reflected in the bottom-line net income figure. This cash flow analysis stuff gets a little complicated, we know, but hang in there. The cash flow statement, presented later in the chapter, makes a lot more sense after you go through this background briefing.

Prepaid expenses increase

The next asset, after stock, is prepaid expenses (refer to Figure 7-1). A change in this account works the same way as a change in stock and debtors, although changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.

Again, the beginning balance of prepaid expenses is recorded as an expense this period but the cash was actually paid out last period, not this period. This period, a business pays cash for next period's prepaid expenses - which affects this period's cash flow but doesn't affect net income until next period. So the £145,000 increase in prepaid expenses from start-of-period to end-of-period in this business example has a negative cash flow effect.

As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in debtors, stock, and prepaid expenses are the price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.

The simple but troublesome depreciation factor