ohn Young is a new assistant controller at Richmond Electronics, a large regiona
ID: 2422946 • Letter: O
Question
ohn Young is a new assistant controller at Richmond Electronics, a large regional consumer electronics chain. Before John’s recruitment, he was aware of Richmond’s long trend of moderate profitability. The reports on his desk confirm the slight, but steady, improvements in net income in recent years. The issue he is facing as he reviews the reports is the decline and erratic trend in cash flows from operations.
2014
2013
2012
2011
Income from operations
$ 140.0
$ 132.0
$ 127.5
$ 127.0
Net income
38.5
35.0
34.5
29.5
Cash flow from operations
1.6
19.0
14.0
15.5
His sketch shows increasing profits but an ominous trend in cash flow, which is consistently lower than net income. Upon closer review, Ben noticed three events in the last two years that, unfortunately, seemed related:
Richmond loosened its credit policy. In other words, Richmond relaxed its credit terms and lengthened payment periods.
Accounts receivable balances increased dramatically.
Several of the company’s compensation arrangements, including that of the controller and the company president, were based on reported net income.
What is so ominous about the combination of events John sees? If you were John, what course of action will you take?
2014
2013
2012
2011
Income from operations
$ 140.0
$ 132.0
$ 127.5
$ 127.0
Net income
38.5
35.0
34.5
29.5
Cash flow from operations
1.6
19.0
14.0
15.5
Explanation / Answer
Richmond Electronics is showing a trend of growth in sales and net income, but the cash flow from operations is alarmingly going down by huge percentages.
This is ominuous as the cash flow is going down mainly due to loose credit policy and exptended payment terms. Cash flow is like oxygen to business and lack of cash flow will cause tremendous problem in the comapny in the form of increased working capital borrowing and higher interest cost.
The compensation arrangement of many decision makers like Controller & President is linked to reported net income, which may lead to unhealthy practice of loose credit policy and higher sales. Excatly that is happening. The sales growth and net income growth is contributed by loose credit policy and higher payment terms. This is also increasing the uncertainty of receivables collection and bad debt expenses.
If I were John , I would have immediately call for restoring normal credit policy as per industry norm. Special attention would have been paid to collect past due. The compensation plan would be liked to growth in net income and growth in net cash flow in equal proportion. I would not compromise on credit policy to gain sales volume and the target performance of sales & marketing would include a targeted maximum bad debt % , Days sales outstanding target apart from sales target.
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