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By Mark A. Hutton, CPA, CFE – Hutton, Kruse & Fink, Ltd., Buffalo Grove, Illinois

Any business without the ability to generate cash from its business activities will not survive. Particularly for a small or new business, cash availability is the most important factor in the business and the sources of the cash are significant factors in determining whether the business is a going concern. Even a business that is profitable can fail if cash is unable to be generated and alternate sources of cash are unavailable.

When evaluating the financial condition of a business, the Statement of Cash Flows is an important tool available to the forensic accountant.

The Statement of Cash Flows reports the sources and uses of cash for the period, as analyzed into three major classifications:

  • Cash flows from operating activities
  • Cash flows from investing activities
  • Cash flows from financing activities

The changes in the sources (positive flow) and uses (negative flow) of cash will result in the net change (increase or decrease) in cash for the business for a defined period of time.

Forensic accountants look for changes in trends of cash flows over several periods in evaluating the health of a business.

Operating Activities

Operating activities include the every day or routine transactions of the business that are considered when determining profit or loss. These activities involve those involved with rendering a service or selling inventory.

Items considered in the determination of cash flow from operating activities include cash received from the sale of inventory or providing a service. Cash used for operating activities includes purchases of inventory, payroll and associated expenses and other routine expenses of the business.

The trends in cash flow from operating activities often have an impact on the flows from investing and financing activities. Businesses with sufficient cash flow from operating activities have less of a need to obtain financing and are often able to repay at least a portion of the business loans during the period under review or apply cash toward the acquisition of building, machinery and equipment.

Businesses that extend too much credit to customers or carry increasing quantities of inventory are often in a position that requires delaying payment to suppliers or obtaining debt in order to continue business operations.

Investing Activities

Investing activities include extending and collecting on loans, purchase and sale of buildings, machinery and equipment and purchasing or disposing of investments. This particular area of the Statement of Cash Flows can provide a wealth of information about the management / owners intentions for the business.

Businesses that are attempting to grow will often acquire buildings and equipment. Businesses that are in need of additional funds or that have equipment that is no longer essential to operations may have disposals of these items in this portion of the Statement of Cash Flows.

Sometimes in an attempt to grow a business, management can cause severe financial stress on overall cash flows if the flow from operations is not increasing sufficiently when cash is used for investing into the business.

Financing Activities

Most people think of financing as a transaction with a third party lender. However financing activities include obtaining funds from owners and investors as well as from creditors. Financing activities include the acquisition of debt as well as permanent investment in the business. Consideration is also given to the repayment of debt, paying off investors and payment of dividends.

Financing from a lender or investor is utilized to help support a business’ needs for operating cash as well as to assist the business in acquiring buildings and equipment.

Cash Flow Information a Piece of the Puzzle

When looking at a series of Statements of Cash Flows in order to identify trends for a business, there is a wealth of information about the strength of a business, and its short term history and prospects for success. The information obtained from the Statement of Cash Flows must be considered in relation to the other information that is discovered during the analysis. No one item in a Statement of Cash Flows can give a definitive answer to a question of financial motive; however the trends identified by analyzing Statements of Cash Flows for a number of periods can give clues about what other questions to ask and areas to explore before coming to any conclusions on motive.

The following article was originally published in the September 2004 issue of The Informant, a bi-monthly publication for members of the Illinois Chapter of the International Association of Investigation Units.