The operations section of the cash flow statement reconciles net income and cash flows by adding back noncash expenses and cash produced by changes in working capital. Increases in current assets and decreases in current liabilities are considered a use of cash that pushes down cash flows from operating activities relative to net income.
To create a strategy that avoids declines in cash from operations, businesses should focus on maximizing net income and optimizing efficiency ratios.
The following factors will all decrease cash flow from operating activities:
1. Dwindling Net Income
The cash flow statement begins with net income, which is equal to the profit reported on the income statement. As the first entry of the cash flow statement, dwindling net income is a major factor causing a decrease in cash flows from operations from one period to the next. Net income reflects the sales and expenses of a business in a given period and provides investors with a picture of the company's operating performance.
2. Declining Sales or Margin Compression
Sales can be negatively impacted by changing economic conditions, loss of pricing power, timing within a product's life cycle or poor operational execution. These shifts can be attributed to declining aggregate demand in the economy, entrance of new competitors or ineffective sales and marketing activity.
Margin compression can occur as a result of aforementioned loss of pricing power, though it may also be attributable to poor expense management internally.
3. Changes in Working Capital
The most significant uses of cash from the operating activities section are usually changes in working capital. Increases and decreases of certain current assets and liabilities are reflected in the cash flow statement. Growth in assets or decreases in liabilities from one period to another constitutes a use of cash and reduces cash flows from operations.
Working capital management is evaluated by efficiency ratios such as inventory turnover, days sales outstanding and days payable outstanding.
Lower Inventory Turnover
Inventory turnover is calculated by finding the ratio or sales in a period to inventories at the end of the period. Lower inventory turnover usually indicates less effective inventory management. Poor inventory management expands the level of inventories on the balance sheet at any given time. This is a use of cash that decreases cash flows from operations.
Growth in Days Sales Outstanding
Days sales outstanding measures how quickly a company collects cash from customers. This metric is calculated by multiplying the number of days in a period by the ratio of accounts receivable to credit sales in the period. If days sales outstanding grows, it indicates poor receivable collection practices. This leads to higher current assets, constituting a use of cash that decreases cash flows from operating activities.
Decline in Days Payable Outstanding
Days payable outstanding measures how quickly a business pays its suppliers. It is calculated by multiplying days in the period by the ratio of accounts payable to cost of revenues in a period. When days payable outstanding declines, the time it takes for a company to settle up with its suppliers declines. This reduces accounts payable on the balance sheet. Reducing current liabilities is a use of cash, and this decreases cash flows from operations.