Intermediate Accounting

Max Stevenson owns a local drug store. During the past few years, the
economy has experienced a period of high inflation. Stevenson has had
the policy of withdrawing cash from his business equal to 80% of the
company’s reported net income. As the business has grown, he has had a
CPA prepare the company’s financial statements and tax returns. The
following is a summary of the company’s income statement for the
current year. Revenue………………………………………………………..$565,000
Cost of Goods Sold…………………………………………….395,000
Gross Profit on items sold……………………………………..$170,000
Operating expenses (including taxes)………………………….110,000
Net Income…………………………………………………….$60,000Even though the business has reported net income each year, it has
experienced sever cash flow shortages. The company has had to pay
higher prices for its inventory as the company tried to maintain the
same quantity and quality of its goods. For example, last year’s cost
of goods sold had a historical cost of $250,000 and a replacement cost
of $295,000. The current year’s cost of goods sold has a replacement
of $440,000. Stevenson’s personal cash outflows have also grown faster
than his withdrawals from the company due to increasing personal
demands. Stevenson asks you as a financial advisor how the company can have
income of $60,000 yet he and the company still have a shortage of
cash.5-62. “The Secret of Cash Flow Patterns”Kara Nemrow, a security analyst for Primer Mead & Co., asserts that
she can tell more about a company’s financial condition by looking at
the trends of the negative or positive cash flows in the 3 categories
than from other information found in the financial statements. She
illustrates her theory with the following pattern of cash flows for
Atlas Security over the past 3 years. 2008 2007 2006
Net Income………………………………. (-) (+) (-)
Cash Flows from:
Operating Activities…………….. (-) (-) (+)
Financing Activities…………….. (+) (+) (+)
Investing Activities……………… (+) (+) (+)

How do you think Kara would analyze this pattern? Do you agree that
analyzing cash flow patterns provides superior analytical information?

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