Chapter 4 - CHAPTER FOUR Measuring and Evaluating Cash Flow...

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CHAPTER FOUR 4 Chapter Introduction: Measuring and Evaluating Cash Flow Measuring and Evaluating Cash Flow 4.1 NEL “Yes, I’ll see him,” Shelagh Frost sighed when the reception- ist asked if she were able to talk to Paul Northey. Shelagh was an investment advisor, and Northey was one of her clients. He was not comfortable with risk, and whenever he showed up unannounced wanting to see her, it was always about a problem in his investment portfolio, and he tended to blame her for problems. In stormed Northey. “I’m both angry and confused, Shelagh,” he said, not waiting to sit down. “You remember last year I bought shares of Guestz Ltd., which everyone said looked like a winner. You said it looked like a winner,” he said accusingly. “Well, the company has been reporting good income each quarter and for the whole recent fiscal year, but I just read in the paper that it is going to have seri- ous trouble paying its debts, and may even have to make arrangements with its creditors to stave off bankruptcy! The share price tanked on this news, before I could sell, so I’ve lost a bundle. What the blazes is going on?” Shelagh started to speak, but Northey didn’t stop. “I thought it might be just one of those things, one of those chances you take. But another of my investments, Belhaeven Inc., which,” he smiled thinly, “I picked out myself, no thanks to you, is doing quite well: it’s the same size as Guestz and is making less profit, but is in no finan- cial difficulty at all, and its price is going up a little. How can Guestz be making an income but not have any cash to pay its bills, while Belhaeven is making less income and has no trouble with cash? How can making an income lead to trouble, and making less income lead to no trouble, and how can two similar companies be so different that way?” “Paul, believe me, I know how you feel,” said Shelagh. “I recommended Guestz to some other people too, and they aren’t very happy either. I’ve spent some time with Guestz’s financial statements, trying to figure out what went wrong with its cash in spite of a rosy income number. Here, look at the company’s cash flow statement with me: it shows what was going wrong.” For information on this topic, please visit the online tutorial at www.gibbins6e.nelson.com
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Chapter 2 focused on the balance sheet, and Chapter 3 explained how the income statement measures performance. In this chapter, we return to the comparison of accrual income and cash income introduced in Chapter 1, which is set out in the fourth statement in the set of financial statements, the cash flow statement . We’ll also see a lot more about cash flow besides that comparison. In this chapter, you’ll learn: Why the cash flow statement is important, why it is arranged as it is, what story it tells about cash flow, and how it completes and complements the story told by the other statements; How to answer Paul’s question about why a good accrual income can exist at the same time as a cash shortage (and,
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