Is America Online out of the cyber woods? Not by a long shot. Rushing to put Its busy-signal customer service debacle behind It, the online giant Is adding an average’ of 1,000 modems a day to reconnect angry subsrlbers. But its financial problems won’t be easy to fix. After taking a massive $285 million hit in the September quarter, America Online Inc. had been telling . analysts to expect break even results this quarter. Instead, AOL says the cost 01 upgrading Its network will postpone profitability until the June quarter:-and . only If more revenue rolls in from new sources, such .
as advertising and online transactions.
AOL’s difficulties have already taken a toll on Its balance sheet. In the December quarter, for which AOl reported a $155 million loss, cash on hand actually grew to $130 . mlllion, thanks to the many customers who had prepaid for one- or .two-year memberships. Yet ADl had negative working capital of $193 mlllion.
In plain terms, that means the $1.7 billion company has mora bills coming due than cash and liquid asseis on hand. If AOl’s operations don’t turn ·the corner as promised, says Abe Mastbaum of money manager American Securities, it forced to raise cash through new bank leans or possibly a stock offering-which would be the. company’s fourth. “The worst time to go to t’1e market is when you need to,” Mastbaum notes. Source: Amy Barrett, “At AOL, MOre Holes by the Minute,” Business Week, February 24, 1997, p. 37, Reprinted by special permission, copyright © 1997 by The McGraw-Hilj Companies,
America Online is struggling with its cash position: Despite having what seems to be a very large cash balance-$ 130 million-more bills are coming than there is cash on hand to pay those bills. This may force the company to generate cash from alternative sources, such as new bank loans or a stock offering.
An income statement is designed to measure the success or failure of the business in achieving its objective of profitable operations. To some extent, a balance sheet shows whether or not the business is solvent. It shows, for example, the nature and amounts of current assets and current liabilities.
From this information, users of the financial statements may compute such measures of solvency as the current ratio and the amount of working capital. However, assessing the ability of a business to remain solvent involves more than just evaluating the liquid resources on hand at the balance sheet date. How much cash does the company receive during a year?What are the sources of these cash receipts?
What expenditures are made each year for operating activities and tor investing and financing activities? To answer these questions, companies prepare a third major financial statement, the statement of cash flows. In Chapter 1, we introduced the idea that investors, creditors, and other external users’ of fInancial statements are Interested in the amount, timing, and uncertainty of future’ cash flows to them. As•a.result, they are interested in cash flow information about the enterprise in which they own stock or to which they have made.loans We introduced the statement of cash flows in cash.
in many subsequent chapters, we explained the cash effects of various transactions. In this chapter we summarlze our
previous discussions and expand on them. We illustrate how a statement of cash flows can be prepared from accrual-basis accounting records and, more important, we explain the differ~nce9betweenaccrual-based measurements and cash flows. In the final section of the chapter, we discuss strategies for improving the net cash flow from operating activities.
STATEMENT OF CASH FLOWS “
Purpose of the Statement The basic purpose of a statement of cash flows is to provide information about the (,CIS” receipts and cash payments of a business entity during the accounting period.
(The term cash nows includes both cash receipts and cash payments.) In addition. the statement is intended to provide imcrmution about all the investing and financing activities of the company during the I “jeu, Thus a statement of cash flows assists investors. creditors. and others in assessing such factors.
• The company’s ability to generate positive cash flows in future periods.
• The company’s ability to meet its obligations andto pay dividends.
• The company’s need for external financing.
• Reasons for differences between the .arnount of net income and the related net cash flows from operating activities.
• Both the cash and noncash aspects of the company’s investment and financing transactions for the period.
• Causes of the change in the amount of cash and cash equivalents between the beginning and the end of the accounting period. In summary, a statement of cash flows helps users of financial statements evaluate a company’s ability to have sufficient cash-both on a short-run and on a long-run basis.
For this reason, the”statement of cash flows is useful to virtually everyone interested in the company’s financial health: short- and long-terin creditors. investors. managementand both current and prospective competitors.
Example of a Statement of Cash Flows An example of a statement of cash flows appears on the following page. Cash outflows are shown in parentheses.In this illustration, nei cash flows from operating activities are dctennid by the direct method. An alternative approach. called the indirect method, i~illustrated later in this chapter”
Classification of Cash Flows . The cash flows shown in the statement are grouped into three major categories
( I ) operating’ activities,
(2) investing activities, and
(3) financing activities? We will now look briefly at the way cash flows are classifiedamong these three categories. Operating Activities The operating activities section shows the cash effects of revenue and expense transactions; Stated another way, the operating activities section c. the statement of cash flows includes the cash effects of those transactions reported in the income statement.
To illustrate this concept, consider the effects of credit sales.
Credit sales are reported in the.income statement in the period when the sales occur, But the cash effects occur later-when the receivables are collected in cash. If these events occur in different accounting periods, the ‘income statement and the statement of cash flows will differ. Similar differences may exist between the recognition of an expense and the related