Your firm may have noticed an unexpected discrepancy between the net income and operating cash
flow for The Pet Shop Boys. This is indicative of disproportionate non-cash income and high volume of
fixed assets. The purchase of one truck in 2010 and another in 2011 have represented two significant
fixed asset additions, each which represented a significant depreciation expense in both years. This
depreciation expense was a primary factor for negative net income in 2011.
However, depreciation expense is not paid for with cash and ultimately has no effect on cash coming in
our out of your business. Such depreciation expenses often cause readers to draw misleading
conclusions from the income statement where it is located.
To better assess the financial health of a firm, the cash flow statement is used. Since it adjusts for
liabilities, receivables, and depreciation it is a more accurate measure of how much cash a company has
generated (or used) than measures of profitability like net income. In fact, many investors may find it to
be a better reflection of reality than the income statement. Also, given that companies require cash to
run its everyday operations, cash flow from operations are likely to highlight any liquidity issues that The
Pet Shop Boys might have.
The Pet Shop Boys currently use sales summaries that break down day by day sales. These summaries
provide a simplified snapshot of how much business the company is generating on a daily basis and the
cash going out on a monthly basis.
On the other hand, a cash flow statement summarizes the entire movement of cash in an entity. The
cash flow statement is the best financial tool to describe the sources of a company’s cash and how it
was spent over a specified time period.
The cash flow statement is important to your firm for three main reasons:
1. The cash flow statement neutralizes the impact of the accrual entries (liabilities, receivables, and
depreciation) on the other financial statements
2. The cash flow statement classifies cash receipts and payments according to whether they stem
from operating, investing, or financing activities providing the reader with an understanding of
the amount of cash a company generates and uses in its specific operations
3. The cash flow statement also tells the reader how much money was spent for items that do not
appear on the income statement, such as loan repayments, long-term asset purchases, and
payment of cash dividends.
We have highlighted some conclusions based on your cash flow statement:
1. Go Dog Services Inc. has notable positive cash flow for operational activities
Having positive operational cash flow is essential to business operations. It means that operations
are generating enough cash from day to day activities to reinvest elsewhere and pay off obligations
Two important trends are the reduction in inventory levels and also the payment of accounts
payable. Reducing your inventory levels contributed significantly to your positive cash inflow and
freed up enough cash to sustain current operations as well as fund future opportunities. Keeping
inventory levels low will be important going forward as inventory represents a significant area
where cash tends to be tied up.
Paying off accounts payable reduces cash inflow, however, indicates that you have enough cash to
pay off your creditors.
Reducing payables have decreased your cash inflows; however, it is good that your debt is being
paid. Please take advantage of any payment discounts vendors offer you.
2. Go Dog Services Inc. has negative cash flow for investing activities
Investing activities represent the only negative cash outflows from your business. It is important to
understand that this is common for start-up businesses, especially in the early years of operation. In
order for new companies to expand, capital asset acquisitions (investing activities) of new
equipment, transportation, and renovations need to occur. Such negative cash flow may simply
mean that the company is purchasing long-term investments for the future of the company. Keep in
mind that although such investing activities are necessary, they also dramatically reduce the
available cash on hand.
For the Pet Shop Boys, the purchase of an additional van represented 2/3 of total investing activities
for the Pet Shop Boys in 2011. It also represented a significant source of cash outflow and reduced
the available cash on hand to pay off debt and expenses in the short term.
Going forward, having negative cash flow for investing activities will be common, especially if your
firm intends to expand its operations. However, it is important to keep in mind that if your firm
requires additional cash flow or a desired cash-on-hand limit, reducing investments can significantly
improve cash flow figures.
3. Go Dog Services Inc. has notable positive cash flow for financing activities
Increasing your loans will continue to increase the amount of cash on hand. This is a good, as long as
you pay off your debt on time and continue to show creditors that your operations are strong.
This will help secure future loans and expand business.
Positive operational cash flows for Pet Shop Boys are indicative of a healthy company. Being able to
generate enough cash from day to day activities is important to being able to pay of obligations in the
short term and fund future long term investments. If transactions continue to occur on a cash basis and
inventory levels are low, operating cash flows will continue to be positive.
Negative cash flow from investing activity is normal for a growing small business. Cash Flows from
Investing Activities must be considered alongside other metrics such as Operating Cash Flows before any
real conclusion can be drawn. For The Pet Shop Boys, strong operational cash flows help offset the
negative cash flow generated from investing in the additional truck in 2011. In addition, positive cash
flow from financing activities also offset the cash outflow caused by investment in an additional truck in
Overall, Pet Shop Boys has no cash flow issues and have more cash coming in than out ($3980.11). This
may not seem like much, but considering the large amount of investment spend on capital assets for
growing companies, this figure is solid.
Most importantly, operating cash flow is positive, while also being large enough to offset the investment
in additional capital assets. Small companies often require loans to generate additional cash flow due to
the large cash outflow often caused by investment in capital assets.
Amazingly, The Pet Shop Boys do not have this problem and have generated positive net cash flow from
all areas in their business. This Positive cash flow translates into less of a need to borrow, more
opportunity to realize price discounts with cash purchases, and an increased capacity to fund the
expansion of the business into new product lines and markets.
1) Current Ratio
The Current ratio is a liquidity ratio that measures the ability to cover short term debt by
assets converted into cash in approximately the same period as short term debt matures.
The Current Ratio for The Pet Shop Boys was 0.16 in 2011 0.30 in 2010. For many industries,
this ratio is a cause for concern as the interpretation indicates that there are only $0.16
cents in assets to meet every $1 of current liability.
There are certain areas to point out when assessing the current ratio
Line of credit reduces the current assets by $41,434.21
$55,095.66 is due to shareholders
Business does not have significant AR, but has significant cash sales
Current assets are significantly reduced with the line of credit at TD Bank. In addition,
current liabilities include $55,095.66 due to shareholders (owners). While the line of credit
is an actual current liability, the amount due to shareholders can be ignored as the
shareholders are also the owners of the company (They will not pay themselves before
other current liabilities are due). If this is the case, the current ratio is closer to 1.
It is important to keep in mind that although the current ratio is a good tool to investigate
company liquidity, it is sometimes it’s misleading. Higher current ratio is not necessarily
mean better liquidity and lower current ratio is not necessarily bad liquidity. A ratio below
one indicates “negative working capital” and is usually a red flag for potential liquidity issues
However, negative working capital is not always bad. In general, the more liquid the current
assets, the smaller current ratio can be without cause for concern. Service oriented
companies like The Pet Shop Boys can generate cash so quickly they actually have a negative
working capital. This occurs because customers pay upfront and so rapidly the business has
no problems raising cash (indicated by low accounts receivable). In these companies,
products are delivered and sold to the customer right away. For the Pet Shop Boys who
operate on an almost strictly cash basis, a negative working capital figure is actually a sign of
managerial efficiency in a business with low inventory and accounts receivable (Negative
Working Capital). This ability to raise cash quickly is omitted in the balance sheet and
therefore missing from the current ratio calculation.
In general, companies that have a lot of working capital will be more successful since they
can expand and improve their operations. Even with a negative working capital figure, The
Pet Shop Boys do not have any issues paying their creditors, and thus the current ratio is not
a good indicator of their working capital situation.
A good level of liquidity is important to safeguard against events that may cause The Pet
Shop Boys to run into tough financial times and prevent shutting down completely or laying
off your work force.High liquidity ensures your company will be able to stay afloat for at
least several months using your cash reserves. The level of liquid assets you should keep on
hand largely depends upon your estimated monthly expenses. In all cases, you should be
able to support the company for at least a month or two; six months is ideal.
2. Quick Ratio
Similar to the current ratio, this financial measure is not a good indicator of the working
capital of the Pet Shop Boys.
3. Gross Profit Margin
The Gross Profit Margin is a financial metric used to assess a firm's financial health by
revealing the proportion of money left over from sales revenues after accounting for the
cost of goods sold. Gross profit margin serves as the source for paying additional expenses
and future savings.
The Gross Profit Margin for The Pet Shop Boys was 0.84 in 2011 0.78 in 2010. The Gross
Profit Margin indicates the 84% of sales in 2011 and 78% of sales in 2010 were left to cover
expenses after subtracting the cost of goods sold.
The increase in Gross Profit Margin is the increase in sales that was not proportional to
increase in cost of goods sold. Cost of goods sold increase by approximately 19% whereas
sales increased significantly by 62%.
In a survey of US based Pet Retailers, the average gross profit margin for pet ancillary
services was 78%.
In the initial two years of operation, The Pet Shop Boys met the US industry average profit
margin. This is an indication that the Pet Shop Boys are efficient in the production and
distribution of services.
4. Inventory Turnover Ratio
The inventory turnover ratio measures the efficiency of the business in managing and selling
its inventory. This ratio gauges the liquidity of the firm's inventory (about).
In 2011, on average, The Pet Shop Boys sold its entire inventory 3.47 times or once every
105 days. In 2010, on average, the Pet Shop Boys sold its entire inventory 2.64 or once
every 138 days. This represented a 32% increase in turnover or 33 days faster inventory was
A high inventory ratio means that the company is efficiently managing and selling its
inventory. The inventory turnover ratio is also an index of profitability, where a high ratio
signifies more profit; a low ratio signifies low profit. Also, quick turnover of inventory means
less funds tied up. However, too high inventory turnover ratios can result in running out of
products too often.
Inventory turnover ratios will fluctuate during the year, and will be especially high during,
peak periods such as holiday seasons.
It is also important to use comparative data such as time series (trend) or company
benchmark with which to compare the Pet Shop Boys inventory ratio in order to analyze
whether it is too high or too low.