4.3.3: Interpreting the Statement of Cash Flows (2024)

The cash balance shows an increase of $57,500 from the previous year. Without looking deeper into the reasons why, a hasty conclusion could be drawn that all is well with Watson Ltd. However, there is trouble ahead for this company. For example, the operating activities section, which represents the reason for being in business, is in a negative cash flow position. The profit that a company earns is expected to result in positive cash flows, and this positive cash flow should be reflected in the operating activities section. In this case, it does not, since there is a negative cash flow of $101,660 from operating activities. Why?

For Watson, both the accounts receivable and inventory have increased, resulting in a net decrease in cash of $143,480. An increase in accounts receivable may mean that sales have occurred, but the collections are not keeping pace with the sales on account. An increase in inventory may be because there have not been enough sales in the current year to cycle the inventory from a current asset to sales/profit and ultimately into cash. The risk of holding large amounts of inventory is the increased possibility that inventory will become obsolete or damaged and unsellable.

In this case, an additional reason for decreased net cash from operating activities is due to a decrease in unearned revenue. This is an interesting issue that needs to be explained more fully. Recall that unearned revenue is cash received from customers in advance of earning the revenue. In this case, the cash would have been reported as a positive cash flow in the operating activities section in the previous reporting period when the cash was actually received. At that time, the cash generated from operating activities would have increased by the amount of the cash received for the unearned revenue. The entry upon receipt of the cash would have been:

When the company provides the goods and services to the customer, the net income reported at the top of the operating section will reflect that portion of the unearned revenue that is now earned. However, it did not obtain actual cash for this revenue in this reporting period because the cash was already received in the prior reporting period. Keep in mind that unearned revenue is not normally an obligation that must be paid in cash to the customer. Once the goods and services are provided to the customer, the obligation ceases.

Looking at the investing activities, there was a sale of a building and a purchase of a long-term investment. The sales proceeds from the building may have been partially invested in the investment to make a return on the cash proceeds until it can be used for its intended purpose in the future. Again, more analysis is necessary to confirm whether this is the case. The sale of the patent also generated a positive cash flow. There was no gain on sale of the patent reported in the income statement, so the sales proceeds did not exceed its carrying value at the time it was sold. Hopefully, the patent sale was not the result of a panic sale to raise additional cash.

Looking at the financing activities the majority of cash inflows for this reporting period resulted from the issuance of additional common shares of $182,200. This represents an increase in the share capital of greater than 25%. Increased shares will have a negative impact on the earnings per share and possibly its market price as well, which may send warning signals to investors. The shareholders were also paid dividends of $42,590, but this amount only barely covers the preferred shareholders dividend of $30,000 () plus its share of the participating dividend. This leaves very little dividend left over for the common shareholders. At some point, the common shareholders will likely become concerned with receiving so little in dividends, along with the dilution of their shareholdings due to the large issuance of additional shares.

When looking at the opening and closing cash balances for Watson, these seem like sizeable balances, but what matters is where the cash came from and whether those sources are sustainable. The $250,000 opening balance was almost entirely due to the $225,000 unearned revenue received in advance, but this is likely not a sustainable source. The ending cash balance of $307,500 is due to the issuance of additional share capital of $182,200 (possibly a one-time transaction) and an increase in accounts payable of $143,000 that must be paid soon. Consider that during the year, the cash from the unearned revenues was being consumed and the issuance of the additional capital had not yet occurred. It would be no surprise, if cash at the mid-year point was insufficient to cover even the short-term liabilities, hence the increase in accounts payable and ultimately the issuance of additional capital shares.

Watson is currently unable to generate positive cash flows from its operating activities. The unearned revenue of $225,000 at the start of the year added some needed cash early on, but this reserve was depleted by the end of the reporting year. In the meantime, without a significant change in how the company manages its inventory and receivables, Watson may continue to experience a shortage of cash from its operating activities. To compensate, it may continue to sell off assets, issue more shares, or incur more long-term debt to obtain needed cash. In any case, these sources will dry up eventually when investors are no longer willing to invest, creditors are no longer willing to loan cash, and no assets worth selling remain. This current negative cash position from operating activities for Watson Ltd. is unsustainable and must be turned around quickly for the company to remain a going concern.

Not all companies who report profits are financially stable. This is because profits do not translate on a one-to-one basis with cash. Watson reported a $77,000 net income (profit), but it is currently experiencing significant negative cash flows from its operating activities.

If sufficient cash is generated from operating activities, the company will not have to increase its debt, issue shares, or sell off useful assets to pay their bills. For Watson Ltd., it increased its short-term debt (accounts payable), sold off a building, and issued 25% more common shares.

Perhaps Watson's negative cash flow from operating activities will turn itself around in the next reporting period. This would be the company's best hope. For other companies who experience positive cash flows from operations, they must also ensure that this is sustainable and can be repeated consistently in the future.