AC302 Unit 6 Cash Flow Interpretation Memo Example

Profit Up Three Years, Cash Down Three Years: A Unit 6 Cash Flow Interpretation Memo for a Refuse Hauler

[Student Name]

Purdue University Global

AC302: Intermediate Accounting III

Unit 6 Cash Flow Interpretation Memo

[Instructor Name]

[Date]

Ostwick Refuse & Recycling, its controller and every amount are composite; the standard, textbook and study cited are real.

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To: Dana Ruiz, Controller, Ostwick Refuse & Recycling From: Accounting student consultant Date: February 12 Subject: What three years of cash flow statements say before the bank renews the revolving line

Summary

Ostwick's earnings are growing, but less of each dollar of profit is reaching the bank account, and the company spent more on trucks than its operations produced last year. The causes are identifiable and fixable: commercial customers are paying more slowly, and a growing share of profit comes from selling retired trucks rather than from hauling. The bank will also ask about a transfer station transaction that brought in cash but is reported as borrowing. I recommend addressing all three in the renewal package rather than waiting for the questions.

The Three-Year Picture

1. Net income: Year 1, $2,100,000; Year 2, $2,500,000; Year 3, $2,900,000.

2. Operating cash flow: $3,800,000; $3,450,000; $3,100,000.

3. Operating cash per dollar of net income: 1.81; 1.38; 1.07.

4. Purchases of trucks and containers: $2,600,000; $3,300,000; $4,200,000.

5. Free cash flow, what operations produced after paying for trucks and containers: $1,200,000; $150,000; negative $1,100,000.

6. Days sales outstanding: 41; 49; 57.

7. Gains on retired trucks as a share of net income: 5.7 percent; 11.6 percent; 18.6 percent.

Operating Quality

For a capital-heavy hauler, operating cash should run well above net income because depreciation on trucks is large and noncash. Ostwick's ratio has fallen from 1.81 to 1.07. Two items explain most of the slide. First, receivables are growing faster than revenue: days sales outstanding rose by sixteen days, which ties up roughly $1.0 million more in receivables than Year 1 terms would. The new commercial contracts signed in Year 2 carry 60-day terms, and several property managers are paying late.

Second, gains on retired trucks have tripled as a share of profit, reaching about $540,000 in Year 3. Those gains are real, but the cash from the truck sales appears in investing, not operating, so profit is rising partly on a source that does not show up in operating cash at all. A gain that large also suggests the trucks were depreciated faster than they wore out, which flatters later years when they are sold.

Profit that depends more each year on selling used trucks and less on collecting from customers is profit of lower quality, and the falling ratio of operating cash to net income is where a lender will see it first.

Research supports reading the ratio this way: earnings that rest heavily on accruals tend to persist less into future years than earnings backed by cash, and investors who ignore the difference are later surprised (Sloan, 1996).

Investing Pace

Capital spending rose from $2.6 million to $4.2 million as Ostwick replaced rear-loaders with automated side-loaders and added containers for the new commercial routes. The spending is strategic, and much of it should lower labor cost per route. But in Year 3 it exceeded operating cash by $1.1 million. The renewal package should show when the new fleet reaches full routes and how much replacement spending will drop afterward.

Financing: The Transfer Station

In Year 3, Ostwick sold its transfer station to an investor for $2.0 million and leased it back for fifteen years with an option to repurchase. Because the repurchase option means control did not pass to the buyer, the transaction failed sale treatment under the lease standard; Ostwick kept the station on its books and recorded the $2.0 million as a financial liability (Financial Accounting Standards Board, 2016). On the cash flow statement it is a financing inflow, not investing. That treatment is correct, but the bank will read it as new debt, because it is.

Recommendations

1. Tighten commercial collections: invoice on route completion and enforce the 60-day terms, aiming to bring days sales outstanding back below 50.

2. Present operating cash and earnings with truck gains shown separately, so the bank sees hauling profit on its own.

3. Explain the transfer station financing and its payment schedule in the renewal package, with the liability included in our own debt ratios.

4. Review the useful lives of trucks, since the size of the gains suggests depreciation runs too fast (Kieso et al., 2019).

References

Financial Accounting Standards Board. (2016). Leases (Topic 842) (Accounting Standards Update No. 2016-02). https://www.fasb.org

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.

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.