| Case
Study — Profit vs. Cash Flow
If you keep your business's books on the accrual
method of accounting, you'll have to make some adjustments
to determine your actual cash flow. These adjustments are
necessary because certain accrual accounting transactions are
taken into account to determine your accrual net profit, even
though these expenses do not currently require a cash outlay.
The following example looks at the adjustments necessary to
convert the accrual profits of Bug Busters Exterminating Service
to its cash flow for its year ending December 31, 2002.
To convert its accrual profit to its cash flow profit, Bug
Busters will need balance sheets
from the beginning and end of the period it wishes to examine.
In this case, Bug Busters will examine the period starting on
January 1, 2002, and ending on December 31, 2002. Below is the
comparative balance sheet provided by Bug Busters' accountant
for December 31, 2001, and December 31, 2002:
Bug Busters Exterminating Service
Comparative Balance Sheets |
| |
12/31/01 |
12/31/2002 |
| Cash |
$17,845 |
$4,375 |
| Accounts Receivable |
12,185 |
27,371 |
| Inventory |
6,034 |
9,133 |
| Property and Equipment |
83,239 |
83,239 |
| Less: Accumulated Depreciation |
(44,826) |
(48,989) |
| Total Assets |
$74,477 |
$75,129 |
| Accounts Payable |
$6,977 |
$7,630 |
| Notes Payable (Bank Loans) |
27,500 |
12,000 |
| Total Liabilities |
$34,477 |
$19,630 |
| Stockholder's Equity |
$40,000 |
$55,499 |
| Total Liabilities and Equity |
$74,477 |
$75,129 |
The conversion process also
requires an income statement for the end of the period under
examination. The income statement of Bug Busters Exterminating
Service for the year ending December 31, 2002 is presented
below. The income statement was prepared using the accrual
method of accounting.
Bug Busters Exterminating Service
Income Statement
December 31, 2002 |
| Sales |
$267,189 |
| Less: Cost of Goods Sold |
132,122 |
| Gross Profit |
$135,067 |
| Less: Operating Expenses |
(115,405) |
| Less: Depreciation |
(4,163) |
| Net Profit |
$15,499 |
Bug Busters will have to adjust its accrual net profit to
determine its cash flow for the year. As a general rule, Bug
Busters can convert its accrual net profit using the following
formula:
Using the formula above, Bug Busters can adjust its accrual
net profit to determine its cash flow for the year:
| Adjustment Description |
Amount |
| Net Profit--December 31, 2002 |
$15,499 |
| Add: |
Depreciation |
4,163 |
| Subtract: |
Increase in Accounts Receivable between 12/31/01 and
12/31/2002 |
(15,186) |
| Subtract: |
Increase in Inventory between 12/31/01 and 12/31/2002 |
(3,099) |
| Add: |
Increase in Accounts Payable between 12/31/01 and
12/31/2002 |
653 |
| Subtract: |
Decrease in Notes Payable between 12/31/01 and
12/31/2002 |
(15,500) |
| Net cash flow for the year ended
December 31, 2002 |
($13,470) |
Bug Busters' accrual net profit and the net cash flow for the
year ended December 31, 2002, report two entirely different
results. The income statement prepared using the accrual method
of accounting reports a profit of $15,499 for the year. However,
in terms of a cash flow, Bug Busters had a negative cash flow of
$13,470 for the same year. In other words, Bug Busters spent
$13,470 more than it collected during the year.
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