Purpose: To help you understand the importance of cash flows in the operation of a small business.
You’ve made an appointment to take your year-end financial statements down to the bank. You know that your banker is usually concerned about two things, your net income and the amount of cash you have. You are a little concerned because you know that your current year net income was down a little bit from the prior year. You figure that a significant cause for the decline was due to a large equipment purchase you made early in the year, which resulted in a lot of depreciation expense. However, as you look at your balance sheet, it says that cash increased from last year to this year. That’s a little puzzling, but you’re hoping the banker can figure it out.
A couple of days later, you get a call from the banker. You’re expecting him to tell you the bank won’t be able to extend any more credit to you because your net income has declined. Imagine your surprise when he tells you how pleased he is with your financial performance this year, and that he doesn’t anticipate any problems extending more credit to you. You want to know what he saw in your financial statements that you didn’t see so you say to him, “Bob, thanks for the good news and the good report on my financial condition, even though our cash increased this year. I was afraid that the decline in our income might cause you some concern. How come it didn’t?”
Requirement
What kind of response do you think that you might get from the banker regarding your net income as it relates to cash flow?