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0789736640_CH05 - Conrad-Ch 05_Iss 4:03 PM Page 105 Working...

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Working Capital and Cash Flow Analysis 5 Cash is the most liquid of all assets, so many managers are particularly interested in how much cash is available to a business at any given time. Because the flow of cash into and out of a business is mainly a matter of investing (purchasing assets) and disinvesting (disposing of assets), an analysis of cash flows can help measure management’s performance. This chapter describes the process of accounting for and analyzing cash flows. Although it doesn’t replace them, the cash flow statement is a useful adjunct to income statements and balance sheets. Using tools that are available to you in the form of different functions and links, you’ll see how to use Excel to convert the information in a balance sheet and income statement to a cash flow statement. To set the stage, the next section discusses how costs are timed. Matching Costs and Revenues Several other chapters of this book mention the matching principle —the notion that revenue should be matched with whatever expenses or assets pro- duce that revenue. This notion leads inevitably to the accrual method of accounting. If you obtain the annual registration for a truck in January and use that truck to deliver products to your customers for 12 months, you have paid for an item in January that helps you pro- duce revenue all year long. If you record the entire amount of the expense in January, you overstate your costs and understate your profitability for that month. You also understate your costs and overstate your profitability for the remaining 11 months. Matching Costs and Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Broadening the Definition: Cash vs. Working Capital . . . . . . . . . . . . . . . . . . . . . . . . 107 Analyzing Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 I N T H I S C H A P T E R
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Largely for this reason, the accrual method evolved. Using the accrual method, you would accrue 1/12th of the expense of the truck registration during each month of the year. Doing so enables you to measure your expenses against your revenues more accurately throughout the year. Similarly, suppose that you sell a product to a customer on a credit basis. You might receive periodic payments for the product over several months, or you might receive payment in a lump sum sometime after the sale. Again, if you wait to record that income until you have received full payment, you will misestimate your profit until the customer finishes paying you. Some very small businesses—primarily sole proprietorships—use an alternative to accrual, called the cash method of accounting. They find it more convenient to record expenses and revenues when the transaction took place. In very small businesses, the additional accuracy of the accrual method might not be worth the effort. An accrual basis is more complicated than a cash basis and requires more effort to maintain, but it is often a more accurate method for reporting purposes.
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