Where'd the Money Go? Reconstructing Cash Flow

Written by:
Matthew Schwartz, CPA CIRA CFE¹
Bederson & Co. LLP; West Orange, N.J.
[email protected]

Web posted and Copyright © February 1, 2004, American Bankruptcy Institute.

ne of the questions frequently asked of a bankrupt entity is, "Where did the money go?" This question can be asked in a variety of contexts. It is sometimes asked some months into a bankruptcy regarding an entity's post-petition cash flow. It is also sometimes asked of the pre-petition cash flow for possible avoidance actions. Although recognizing that there is no substitute for tracing disbursements through canceled checks and other bank debits, important summary information can often be determined from analysis of the income statement and balance sheet.

Generally Accepted Accounting Principles (GAAP) require cash flows to be reported in specific categories of Cash from Operations, Cash from Investing Activities and Cash from Financing Activities, among other disclosures. These details are not relevant for the current discussion. The purpose of this article is to provide insight into determining the elements of cash flow from balance sheets and income statements that accompany basic monthly operating reports. Further, accounting rules differentiate between cash-flow analysis using the "direct method" and cash-flow analysis using the "indirect method." The direct method requires access to an entity's books and records, whereas the indirect method requires only the availability of the balance sheet and income statement. This column deals with the indirect method.

In trying to determine the cash flow of an entity, it may seem reasonable to start with net income and add back non-cash items such as depreciation and amortization. However, this is only the start of the analysis. Other common elements that must be considered include items such as billings (accounts receivable) included in income but for which cash has not been collected; alternatively, cash may have been collected in the current period for billings in a prior period. Billings in the current period for which cash has not yet been collected must be subtracted from income to arrive at cash changes, while cash collected in the current period for billings in a prior period must be added to income to arrive at cash changes. Since a reader of financial statements does not know the details of which specific billings were collected in the current period, they are netted for purposes of cash-flow analysis.

Inventory is another element to be considered. When inventory increases during a period, that is a use of cash that must be subtracted from income; alternatively, a decrease in inventory means that the inventory generated cash during the period and must therefore be added back to income.²

Did the entity prepay insurance, supplies or other necessities? These are additional uses of cash not captured in an income statement. Did an entity purchase fixed assets? Again, this is use of cash not captured in the income statement. Alternatively, if an entity disposed of a fixed asset, only the gain or loss would be part of its income statement. The basis of the disposed asset would also be a source of cash that needs to be added to income.

In summary, any increase in assets is a use of cash, and any decrease in assets is a source of cash that requires adjustment to income to arrive at cash changes.

On the liability side, the opposite relationship holds. For example, an increase in accounts payable means that an entity has obligated itself to creditors, but has not yet paid its debt. Therefore, an increase in accounts payable must be added back to income to properly show cash changes.

If an entity borrowed money, it has a source of cash that is not reflected in the income statement and so must be added back to income to show cash changes. Similarly, if debt was paid down, that is a use of cash not reflected in the income statement and so must be subtracted from income. While GAAP requires such borrowings and payments to be shown separately, for purposes of determining what happened to cash that detail may not be necessary, although further investigation may be required.

Similar logic can be applied to the remaining items on the balance sheet. For example, dividend payments paid to shareholders would be a use of cash not reflected on the income statement.

In summary, any increase in liabilities or equity is a source of cash, while decreases in liabilities are a use of cash that requires adjustment to income to arrive at cash changes.

In the exhibit on p. 45, a hypothetical income statement and a comparative balance sheet shows changes in assets and liabilities for Whatawaytogo Inc. Also presented is a basic cash-flow analysis that has been generated strictly from the other two reports. The descriptions in the cash-flow analysis indicate the source of the information from the other statements. (Note that the cash-flow analysis is not in accordance with GAAP, which, as suggested above, may not be necessary for these purposes.)

In this admittedly simplified analysis, Whatawaytogo's balance sheet and income statement appear to show a relatively healthy company at first glance. However, with a strong income statement and balance sheet at year end 12/31/X3, one may well wonder, "Where did the cash go?" Comparing cash from 12/31/X3 to the prior year, it has decreased by 90 percent.

Calculating the changes in assets and liabilities, sources of cash include operations ($5,500, adjusted by $2,000 for non-cash depreciation), long-term debt ($16,000) and non-payment of accounts payable ($21,000). Uses of cash include inventory ($22,000), fixed assets ($5,000) and prepaid expenses ($500), while $26,000 of accounts receivable have not been collected.

It is clear from this example that Whatawaytogo has taken on debt to finance its working capital (accounts receivable and inventory). This suggests that further investigation of the working-capital accounts may yield additional useful information. The investigation may determine that the additional debt-financed growth in the company and cash flow will catch up in the next period. However, this set of circumstances also may indicate fraudulent reporting in accounts receivable and inventory, two of the easiest areas to manipulate on a balance sheet. Further investigation may center on confirming receivables, performing a physical inventory and looking for large or unusual adjustments in Whatawaytogo's accounts, especially at or near year's end.

One other concept requires attention when analyzing cash flow in the manner suggested. Because this analysis ties cash flow to both the income statement and the balance sheet, the change in cash balances MUST be derivable from the analysis. If cash changes cannot be reconciled from such an analysis, this is a strong indication that the basic financial statements have not been prepared properly, either through lack of expertise or fraud. If this is the case, further investigation would be required to determine the reasons for the lack of the required relationships.

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Footnotes

¹ Matthew Schwartz is a partner in the Insolvency and Litigation Services Department of Bederson & Co. LLP. An officer of the Association of Insolvency and Restructuring Advisors, he has spent the past 15 years investigating and consulting on matters related to insolvency, bankruptcy and related litigation. Return to article

² The astute reader may protest that an increase in inventory may not yet have been paid, and therefore should not be subtracted from income, or that a decrease in inventory may have been the result of shipping and billing, but may not yet have been collected. The former would be dealt with in changes in accounts receivable, previously discussed. The latter would be dealt with in changes in accounts payable, discussed below. Return to article

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