John 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.
John sketched the following comparison ($ in millions):
Income from operations
Cash flow from operations
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?