Question

Katie Murphy is preparing for a meeting with her banker. Her business is finishing its fourth year of operations. In the first year, it had negative cash flows from operations. In the second and third years, cash flows from operations were positive. However, inventory costs rose significantly in year 4, and cash flows from operations will probably be down 25%. Murphy wants to secure a line of credit from her banker as a financing buffer. From experience, she knows the banker will scrutinize operating cash flows for years 1 through 4 and will want a projected number for year 5. Murphy knows that a steady progression upward in operating cash flows for years 1 through 4 will help her case. She decides to use her discretion as owner and considers several business actions that will turn her operating cash flow in year 4 from a decrease to an increase.

Required

1. Identify two business actions Murphy might take to improve cash flows from operations.

2. Comment on the ethics and possible consequences of Murphy’s decision to pursue these actions.

Short answer

1. Cash flow can beimproved by reducing the outflow occurring through operating expenses.
2. Reporting false information on the cash flow statement will mislead the investors and affect their decisions.

Step-by-step solution

Definition of Cash Flow from Operation

Cash flow from operation includes all the cash inflows and outflows from daily business operations. It includes cash inflow from sales of products and cash paid to the vendor for the inventory acquisition.

Actions for improving the cash flow from operations

Two actions that a business entity must take to improve the cash flow from operations are:

1. Murphy can postpone the payment made to vendors and operating expenses to reduce the cash outflow and report a higher cash balance.
2. Murphy can also reduce the salary she paid herself to reduce the cash outflow and increase the cash balance.

Ethics and possible consequences of Murphy’s decision to pursue these actions

Presenting false information in the cash flow statement is considered unethical because such information will mislead the decision makers, such as investors and the company’s management.