There may be cases where even before receivables are yet to be realized the company records cash on its books. In other words, the company shows increases its cash balance but the payment from the vendor is yet to be received. Take the case of CG Power and Industrial Solutions which was in the news off late for misrepresenting its financial statements. CG Power was to receive monies from promoters and subsidiaries, however before it received the cash, the company recorded these monies as part of the bank balances.
These have been restated as receivables for the period to which they pertain. Take one more case where receivables were netted off inappropriately. In the above case the action of netting off reduces receivables to the tune of amount, Rs Cr in this case. Reduction in the receivable balance boosts the CFO. For instance in this case Cr of working capital in the form of receivables was freed up and assuming that the receivable balance remains constant, this amount is reduced to arrive at the final CFO.
One more instance where the receivables had to be reinstated. The company prior to taking this step had adjusted the loan with its retained earnings, however the loans and receivables have been treated accordingly. Shifting of normal operating expenses from the operation section also gives a boost to the CFO.
Operating costs are normally shifted to the cash flow from investing section. Capitilizing expenses also gives a boost to the CFO. Let us see how this leads to an increase in CFO.
When companies capitilize expenses they are put on the balance sheet as an asset. The starting point of arriving at the CFO is earnings before tax EBT , this is the indirect method of preparing cash flows. The asset purchase is recorded as an investing outflow in the cash flow from investing section. This means that the company is not able to generate enough cash from its operations to meet its CAPEX requirements, they would need to raise debt or issue stock to meet this shortfall.
It may be the case that the company has to make investments as it sees an opportunity to create the CAPEX that it is doing, or there also may be a possibility that it is capitilizing its costs. There may be instances where purchase of inventories, which should appear on the CFO section are shown as investing cash outflows and do not appear in the CFO section, thereby overstating the CFO.
However to boost its CFOs, companies may record these as investing cash outflows and record them in the cash flow from investing section. CFOs take a boost, when companies undertake certain unsustainable activities. Primarily these manage the cash conversion cycle — inventory, receivable and payable days to boost their CFOs. For instance a company may be collecting its receivables faster and as a result its receivable days will go down.
This may be due to various reasons — efficiency in collections, discounts to vendors to buy products on cash or aggressive approach towards collections. We need to ascertain the reason for faster collections and understand if this is sustainable. In the case of payables, companies may be deliberately paying their customers late or may be under financial stress.
The agency buying the accounts receivable pays the company a certain amount of money, and the company passes off to this agency the entitlement to receive the money that customers owe. In doing so, Jack Corporation shifted the future period cash flows to the current period, thereby again inflating the CFFO.
The time between sales and collection is shortened, but the company actually receives less money than if it had just waited for the customers to pay. Deflating Operating Cash Outflows.
Improperly capitalizing operating costs. Operating costs are the costs incurred by the business in its day-to-day activities like payment to suppliers for raw material, salaries etc. However, sometimes companies can record some costs as an asset and shift it to the cash flow from investing section. For instance, WorldCom, classified billions of dollars of operating costs as capital equipment purchases.
It thus improperly inflated its earnings by recording its line costs an operating cost as an asset rather than an expense. Simply put, WorldCom shifted a large cash outflow from operating to investing section. Recording purchase of inventory as Investing Outflow. Cost of goods sold COGS are the direct expenses incurred by a company in acquiring or producing its goods inventory. Curiously, some companies falsely treat these purchases as an investing outflow.
In doing so, they shift the cash outflow from the operating to investing section. Result is an inappropriate increase in the CFFO figures. To summarize though it is difficult manipulate a cash flow statement, there are still many ways in which a company can manipulate it. Given below is a checklist that will help us investors in detecting such manipulations. If you liked what you read and would like to put it in to practice Register at MoneyWorks4me.
Need help on Investing? And more …. Puchho Befikar. Started in ; experienced in equity research, financial planning and portfolio management. Passionate about providing institutional quality research and advice to Retail Investors in a simple easy-to-understand-and-act manner. I am a retired senior banker. The Banks are still follwoing 2nd method of lending or turnover method keeeping in view the exposure except IT, contractors etc. Thanks a lot for the appreciation. Yes, you are right in saying that banks should assess the cash and funds flow statement.
It would help them to avoid lending to fraudulent companies. Good explanation. It seems we cannot directly take the total figures as granted. Ostensibly, the cash flow is the difference between how much money is generated versus how much is spent on operations. However, it isn't always that straightforward. Companies are fully aware that investors and lenders are monitoring their cash flow statements. Accountants sometimes manipulate cash flow to make it appear higher than it otherwise should.
A high cash flow is a sign of financial health. A better cash flow can result in higher ratings and lower interest rates. Companies often finance their operations by raising equity capital or through debt, and it is extremely useful to be able to present a healthy company. Study a company's cash flow under its operating cash flow entry. This is in the cash flow statement, which is presented after the income statement and the balance sheet.
Operating cash flow can be distorted in several different ways. Accountants have to determine when to recognize payments made by the company, which are recorded under accounts payable. Suppose a company writes a check and does not deduct that payable amount before the check is actually deposited, allowing the funds to be reported instead in operating cash flow as cash on hand.
Another technique that a company might use involves paying overdrafts. Generally accepted accounting principles allow overdrafts to be added into accounts payable and then combined with operating cash flow, making it appear larger than it otherwise should.
Companies sometimes generate income from operations that are not related to their normal business activity, such as trading in the securities market.
These are typically short-term investments and have nothing to do with the strength of the business's core model. If the company adds these funds into its normal cash flow, it gives the impression that it regularly generates more receivables through its standard operations than it actually does. The working capital accounts are most directly responsible for the reporting of cash flow.
Receivables increase cash flow, while accounts payable decrease cash flow. A company could artificially inflate its cash flow by accelerating the recognition of funds coming in and delay the recognition of funds leaving until the next period.
This is similar to delaying the recognition of written checks.
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