Accounts Payable

Accounts Payable is a current liability account that is credited when a company has received goods and/or services on credit terms. (The debit often involves an expense or asset account.) One practice is to credit Accounts Payable only after a three-way match has taken place. This means that the vendor's invoice, the company's purchase order, and the company's receiving report are reviewed and are in agreement. When the company pays a previously recorded amount, Accounts Payable will be debited and Cash will be credited.

If a company has incurred an expense and/or a liability, but the vendor's invoice has not yet been recorded in Accounts Payable as of the end of an accounting period, it will have to be recorded through an adjusting entry which will likely credit a current liability account such as Accrued Liabilities, Accrued Expenses, or Accrued Expenses Payable.

It is beneficial for a company's cash balance and liquidity to seek credit terms (or trade credit) from the vendors that provide goods and services. It is also helpful for the company to use a business credit card. (This will be discussed in the next section.)

Increasing accounts payable or accrued liabilities instead of paying cash will not change the amount of the company's working capital. However, the company will have more cash on hand because of the delay in paying out cash. The higher cash balance will result in additional liquidity at least temporarily. The current ratio will change slightly depending on the amount of the current assets and the current liabilities.

Business Credit Card

A business credit card is a convenient way for a company to pay some of its obligations without immediately reducing the company's cash. Assuming that a company has a business credit card and that a vendor accepts it as payment, the company will gain 27 to 57 days before having to pay the credit card company. In the meantime, the vendor receives its money (minus a 3-5% fee) from the credit card company within a few days of the transaction. It is also possible that the company paying with the business credit card will receive a cash rebate of 2% from the credit card company.

The business credit card transactions which are not yet paid must be reported as an accrued liability. Therefore, the use of a business credit card will not give the company any additional working capital, but the company will have some additional liquidity from holding its cash for the 27 to 57 days until the credit card statement becomes due.

To learn more see our topic Accounts Payable.

Statement of Cash Flows

Since the accrual method of accounting is the general rule for financial statements that are distributed to people outside of the company, a company's income statement will be reporting the revenues earned (not its cash receipts) and the expenses that occurred (not the cash it paid out). Since some users of the financial statements need cash flows for a variety of financial models and analyses, the accounting standards require that a statement of cash flows (SCF, or cash flow statement) accompany a company's balance sheet, income statement, and the other financial statements distributed outside the company.

The SCF identifies the major cash inflows and cash outflows that occurred during the accounting period of the income statement. The cash inflows and outflows also reconcile the change in the amount of cash and cash equivalents from the beginning of the year to the end of the year. Seeing the sources and uses of cash for a recent time period may provide insights regarding the company's liquidity.

The SCF organizes a company's main cash flows into three major sections:

  1. Cash flows from operating activities which typically begins with net income and then adjusts for the changes in the balances of the working capital accounts (except for short-term loans which are included as part of financing activities). There are also adjustments for noncash income statement items such as depreciation and amortization expenses as well as gains and losses on the sale of long-term assets.
  2. Cash flows from investing activities which includes the purchase and/or sale of long-term assets
  3. Cash flows from financing activities which includes borrowing and repaying of short-term and/or long-term debt, issuing or reacquiring capital stock, and payment of dividends

In the three major sections of the SCF:

  • Cash inflows appear as positive amounts to indicate that they have a positive or favorable effect on the company's cash balance. For example, if a company sells additional common stock, the amount received will be shown as a positive amount in the section cash flows from financing activities.
  • Cash outflows are shown in parentheses to indicate they have a negative or unfavorable effect on the company's cash balance. For instance, if a company purchases new equipment, the amount spent will be shown in parentheses in the section cash flows from investing activities.
  • The cash inflows and the cash outflows in each section of the SCF will be summed and the resulting net amount for each section is shown. For example, if a company sold one of its delivery vehicles for $10,000 and it purchased equipment for $50,000, the section cash flows from investing activities will show:
working-capital-exp11

Cash flows from operating activities

The first section of the statement of cash flows (SCF) will likely have a heading similar to one of the following:

  • Cash Flows from Operating Activities
  • Operating Activities
  • Cash Provided by Operations

The total or net amount of the first section of the SCF is often described as:

  • Net cash provided by operating activities
  • Cash provided by operations

In the U.S., the FASB allows for this first section of the SCF to be presented in one of two ways: the direct method or the indirect method. Even though the FASB prefers the direct method, nearly all corporations have chosen to use the indirect method. Therefore, our discussion is limited to the indirect method.

Under the indirect method, the section cash flows from operating activities (CFOA) begins with the amount of the net income that was reported on the company's income statement. Since the net income was determined using the accrual method of accounting, there will be some revenues, expenses, gains, and losses reported on the income statement that did not involve cash during the accounting period. Two examples are depreciation and amortization expenses. Therefore, those amounts will be shown as an adjustment to the net income.

Next, the CFOA will list the adjustments to the working capital accounts (other than short-term loans which will be reported in the financing activities section). These adjustments are necessary to convert the accrual method amounts on the income statement to become the cash method amounts. Basically, the amount of the adjustments will be the change in the working capital accounts such as the following:

  • Accounts receivable
  • Inventory
  • Prepaid expense
  • Other current assets
  • Accounts payable and accrued expenses
  • Income taxes payable

Here are some of the common items appearing in the cash flows from operating activities (CFOA) section along with hypothetical amounts:

  • Assuming the income statement reported net income of $59,000, the CFOA will begin with 59,000 as a positive amount. [A net loss would be shown in parentheses.]
  • If the income statement included depreciation expense of $13,000, the CFOA will report 13,000 as a positive amount. The amount of the depreciation must be added back to the amount of the net income because the depreciation entry reduced net income, but cash was not used.
  • If accounts receivable increased by $12,000, CFOA will report (12,000) because it was not good (it was unfavorable) for the company's liquidity to have accounts receivable increase instead of receiving cash at the time of the sale. [Had there been a decrease in receivables there would have been a positive adjustment. The reason is that converting more receivables to cash would have been good or favorable for the company's liquidity.]
  • If inventory decreased by $3,000, CFOA will report 3,000. It is a positive amount since converting inventory into cash during the accounting period was good for the company's cash balance and the company's liquidity.
  • If accounts payable increased by $7,000, CFOA will report 7,000. It is a positive amount since it was favorable for the company's cash balance and liquidity to delay paying some bills. [A decrease in payables would require a negative adjustment.]

The above items will appear in the CFOA section as follows:

working-capital-exp12

Note:
In the section entitled cash flows from operating activities the positive amounts indicate that more cash was received than indicated by the company's net income shown on the income statement. Negative amounts indicate that less cash was received than the net income reported on the income statement.

You can also think of the positive amounts as being positive, good, or favorable for a company's liquidity. Negative amounts can be thought of as not good or unfavorable for a company's liquidity.

Knowing more about the cash that a company has been generating from its business operations (operating activities) is important for learning more about a company's liquidity.

You will find that U.S. corporations with common stock that is publicly traded will cite amounts from the CFOA section of the SCF when discussing the corporation's liquidity in their Annual Report to the Securities and Exchange Commission (Form 10-K).

Operating cash flow ratio

A financial ratio that uses a statement of cash flows (SCF) amount to indicate the adequacy of a company's working capital and liquidity is the operating cash flow ratio, which is computed as follows:

Operating cash flow ratio = net cash provided by operating activities divided by the average amount of current liabilities.

If the net cash provided by operating activities is taken from the SCF of a recent year, it should be divided by the average amount of current liabilities throughout the same year. (Using only the amount of current liabilities at the final moment of an accounting year may be misleading.)

To illustrate the calculation of the operating cash flow ratio, let's assume that a company's SCF for the prior year reported net cash provided by operating activities of $200,000. For the same year it was determined that the average amount of current liabilities during the year was $300,000. Inserting those amounts into the formula, we have:

Operating cash flow ratio = net cash provided by operating activities divided by average current liabilities = $200,000 divided by $300,000 = 67%, or 0.67:1, or 0.67 to 1

Note:
To become more familiar with SCF, we have a separate topic on the cash flow statement that includes a detailed explanation, practice quiz, Q&A, quick tests, and more.