BUS 510 Module 2 Building the Statements Example

Profitable and Short of Cash: Building and Reading the First-Year Financial Statements of a Commercial Cleaning Company

Student Name

MBA Program, Aspen University

BUS 510: Managerial Accounting

Instructor Name

Month Day, Year

Profitable and Short of Cash: Building and Reading the First-Year Financial Statements of a Commercial Cleaning Company

Lisa Okafor-Hayes left a facilities management job to start Clearwater Commercial Cleaning, a composite company in Tulsa, Oklahoma, that cleans offices, medical clinics and schools at night. Twelve months in, she had 31 people on payroll, had won contracts with 46 clients and, according to her bookkeeper, earned a healthy profit. Yet twice in the final quarter she had to transfer money from her personal savings to meet payroll. This paper builds the company's three financial statements for its first year and uses them to explain how a profitable business can run short of cash.

The Income Statement

The income statement reports revenue earned and expenses incurred during the year, whether or not cash changed hands.

Net income is about 10.3% of revenue, a reasonable margin for commercial cleaning. Because the company is a limited liability company taxed as a sole proprietorship, income tax falls on the owner rather than the business and does not appear here.

The Balance Sheet

At the close of the year, Clearwater's resources and obligations stood as follows.

The largest asset after equipment is accounts receivable: clients owe the company $155,000, about a month and a half of revenue, because most contracts allow payment within 45 days.

The Statement of Cash Flows

Here the year's cash movements are traced line by line. Prepared by the indirect method, its operating section starts with net income and adjusts for items that affected profit and cash differently.

How the Statements Connect

The three statements form one system. Net income of $128,000 from the income statement enters owner's equity on the balance sheet, together with contributions and draws. The statement of cash flows begins with the same net income and ends with the $39,000 cash balance shown on the balance sheet. Every change in a balance sheet account appears somewhere on the cash flow statement: the growth in receivables in operating activities, the equipment in investing activities and the loan and owner transactions in financing activities. If any of these failed to agree, the statements would contain an error.

Why Profit and Cash Differ

The statements answer Okafor-Hayes's puzzle. She earned $128,000, but clients had not yet paid $155,000 of the revenue she recognized, so operating activities produced only $19,000 of cash. Meanwhile, she spent $150,000 on equipment and drew $70,000 for living expenses. Her contributions and the bank loan covered the gap, but only barely, and the timing of collections left payroll weeks without enough cash.

Accrual accounting records the effects of transactions in the periods when they occur, rather than when cash is received or paid, because this gives a better picture of performance (Financial Accounting Standards Board, 2010). Research supports that view. Dechow (1994) showed that, over short intervals, earnings track a firm's performance more closely than cash flows do, since accruals absorb timing swings like Clearwater's slow collections. Sloan (1996) added a caution: the part of earnings made up of accruals tends to persist less into the future than the cash part, and investors often fail to account for this difference. Together, these studies suggest that managers should read both measures, using profit to judge performance and cash flow to judge whether the business can sustain itself.

Reading the Statements as a Banker Would

A lender renewing Clearwater's loan would read the three statements in a particular order. The income statement shows that the business model works: contracts are priced above the cost of labor and supplies. The balance sheet shows where the risk sits, in receivables equal to about six weeks of sales and in a loan that still has $80,000 outstanding. The cash flow statement shows that operations alone barely covered themselves in year one and that the owner's own money carried the expansion. A banker would want to see operating cash rise in year two as receivables stabilize, and would ask how quickly the largest clients actually pay.

What the Owner Should Do

Three changes would ease the pressure. First, new contracts should require payment within 30 days, with a small discount for payment within 10, which could reduce receivables by roughly a third. Second, the company should arrange a revolving line of credit sized to about a month of payroll, so that timing gaps do not reach the owner's savings. Third, the bookkeeper should prepare a short monthly cash report showing collections, payroll and expected receipts for the next eight weeks.

Conclusion

Clearwater's first year was profitable by the income statement and nearly insolvent by the bank balance. The three statements, built and read together, show exactly why: growth in receivables and a large equipment purchase absorbed cash faster than operations produced it. Accrual profit measured the company's performance well, but cash flow measured its survival, and a manager needs both.

References

Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18(1), 3-42. https://doi.org/10.1016/0165-4101(94)90016-7

Financial Accounting Standards Board. (2010). Statement of Financial Accounting Concepts No. 8: Conceptual framework for financial reporting. FASB.

Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289-315.