Question

Your best friend just lost his job because the company he was working for went bankrupt. He was complaining to you that even though the company had been profitable for three years in a row, it still went out of business. He asks you how this can happen. Explain the most likely reason for the company declaring bankruptcy. Could your best friend have seen it coming? How?

Answer 1

The reason for bankruptcy is the cash flows of the firm. A Higher profitable firm need not be solvent if its cash flows are not well managed. For example if it has higher inventory and receivables the cash flows can be lower than the net profit reported. The net income and expense is reported based on the accrual concept in Income statement and hence it ignores the cash flows of the firm. The cash flows of the firm is the key to remain solvent and net profit is not the indicator of solvency

Yes, my best friend could have seen it coming by reading the cash flow statement which is part of the financial statements published. Cash flow statement gives details of movement in cash and cash equivalent during the year. Hence it is made mandatory to be given as part of financial statements. Cash flow statement shows sources of cash and how it is used in the business. It classifies activities into operating, investing and financing.