AIS Cash Flow Essay

Length: 8 pages Sources: 8 Subject: Economics Type: Essay Paper: #40432060 Related Topics: Wealth, Accounting Information Systems, Managerial Accounting, Taxation
Excerpt from Essay :

Accounting

The role of the firm in the economy is to maximize shareholder wealth (Friedman 1970), owing to the agency role that managers play, where they safeguard the wealth of the investors. Given this reality, managers are obligate to seek out ways to increase the profits of their companies. There are as many ways to earn profits as there are companies, but this paper is going to focus on a particular approach, which is cash management. For a business, cash is the ultimate goal, as the fungible store of wealth that the shareholders seek. Yet for the business, cash is also a source of inefficiency. Unused cash on the balance sheet earns nothing, and cash sitting in short-term investments is unlikely to have a positive real return either. Apple shareholders recently demanded that the company return some of its excess cash to the shareholders as dividends, because of how inefficient excess cash is for a company (Popelka 2013).

Thus, the manager is responsible for striking the right balance between spending money to earn returns, and returning that wealth to the shareholder. The company must acquire cash and then quickly use that cash to either generate more, via retaining the earnings and reinvesting in the company, or by returning the cash to the shareholders. For the manager, then, it is imperative to manage the organization's cash closely. This mandate is reflected in the concept of the cash conversion cycle. The cash conversion cycle reflects the degree to inventory is converted to cash, and how fast that cash is converted back into other goods and services. Richards and Laughlin argued in 1980 that managing the organization's cash "receives less attention in the literature than long-term investment and finance decisions, but occupies the major portion of the financial manager's time and attention." They tied the concept of cash conversion cycle to liquidity -- and this approach remains relevant today -- but even in companies where the overall liquidity position is not in doubt, there is need to manage cash effectively, to increase profits and returns for the shareholders.

How Cash Affects Profits

The case of Apple makes a good starting point for understanding how cash affects profits, because of its extreme nature. For most companies, cash is a lifeblood, and the firm's managers approach cash from a liquidity perspective, always seeking to ensure that the company maintains liquidity. Where liquidity is a genuine concern, that approach makes sense, because creditors are superordinate to equity holders -- liquidity is therefore more important to shareholder returns. In most firms, therefore, the intensive management of cash is not viewed as a pathway to profitability so much as a pathway to survival.

Apple found itself in a different situation, where it was making billions every year. Apple did not have enough viable projects -- especially when its hurdle rate for new projects was probably very high -- to invest all of the cash it was bringing in. The company therefore parked billions in near-cash investments, some long-term. But these investments in a low-interest rate environment were earning much less than the company's ordinary activities. Furthermore, some of these earnings were overseas, and Apple was reticent to repatriate these earnings and pay the higher U.S. tax rates. Thus it was becoming a serious issue for Apple investors -- the company had a lot of cash that on which it could not earn a positive real return, it did not want to repatriate the money, but the overall effect on the company was to lower the ROE, something the shareholders took notice of (Le Guyader, 2014). This reality has presented a problem for other companies as well, mainly in software and technology. Cash management at this point is more about maximizing shareholder wealth through avoiding taxes and finding viable uses for the cash (either investments or dividends) than it is about liquidity.

Thus, excess cash creates inefficiency, and this inefficiency thereby reduces shareholder returns by way of reducing the return on equity that that company earns....

...

But companies cannot simply invest in inventories or assets, as those could lose value, and similarly companies must be careful about what businesses they plow their free cash flow into. There is also always the risk that the company's fortunes turn, something that will require the company to start thinking about liquidity. There are a lot of good reasons, it seems, to manage cash flow as efficiently and effectively as possible, as a means of not just maintaining solvency by increasing shareholder wealth.

Accounting Information Systems

An information system is simply defined as a system by which information is gathered, stored and then disseminated. An accounting information system is one that tracks financial and accounting data specifically, and in general the terminology refers to computer-based systems (Investopedia, 2014). An accounting information system collects data from points around the company, and aggregates this into accounts. The system basically takes each individual transaction as reported, and in many cases the AIS is linked to the point-of-sale terminals in order to gather the information about each transaction individually and in real time. The AIS, in essence, puts all of the transactions into t-accounts, and does this over the scale of the entire company.

A manager using an AIS is not going to look at individual transactions without a compelling reason, but will be able to view and print out information on aggregate. At their most powerful, an AIS will be live, and a manager could theoretically at any point in time get a live balance sheet from the system, showing the company's exact cash position. Granted, many such AIS systems are not robust enough to do this, and most companies maybe do not need data that frequently in order to make sound cash management decisions, but the fact that this is possible raises opportunities for managers to improve profitability through analysis of their organization's cash flow patterns.

This is not the most valuable part of AIS with respect to cash management, but rather the information can be used to define trends and extrapolate future cash positions. The larger the company, the more complex this task would otherwise be. While there is little doubt that a hot dog stand can handle this task without the benefit of expensive software, it is equally certain that a multinational conglomerate needs highly-sophisticated software in order to provide sufficient breadth and depth of information to affect overall profitability.

As with any strategic initiative, the organization needs to first determine its strategy, and then use the information provided to set a strategy for the future. The ideal system would not only allow managers to model future outcomes based on a past-performance "base case" scenario, but would allow for sensitivity analysis to illustrate how different strategy choices will affect cash flow, the cash conversion cycle and net income.

Specific Areas

Managing cash to increase profit means that all aspects of the organization can be subject to adjustment. One of these, as noted, is the issue of taxation. Taxation does not affect operations so much as it affects shareholders, for two reasons. First, taxes should always be minimized in order to enhance shareholder returns, because those returns are on an after-tax basis. Second, when taxes make it difficult for American companies to repatriate profits earned overseas, it also leaves the company with less money available for investment, even when the company is wildly profitable. This is where the AIS comes into play, because an AIS can allow managers to analyze cash flow under different scenarios and determine what the most profitable option. For example, it may be that holding the capital overseas, unused, is the best option, but it may also be the case that the best option is to repatriate the capital, or move it to a third-party country. Analysis of cash flows on this level requires advanced cash flow modeling software, something a top end AIS system can do.

There is also a relationship between cash flows, earnings and book value, as explained in Hanlon (2005). Hanlon notes that firms with small book value-tax differences tend to have better earnings. This is intuitive logic -- smaller book-tax differences imply that a company has greater earnings stability, and that should allow managers to make better decisions regarding assets to maximize profitability than managers in company where it revenues and taxes are more volatile.

Accruals actually end up being a huge issue, because the rate of accruals will affect the value of future cash flows. These may not affect the net income in the short-run, but with writedowns they will affect net income in the long-run, and therefore will affect long-run shareholder wealth (Barth, Cram & Nelson, 2001). AIS software can account for accruals in the modeling of future cash flows, based on the past data that has been gathered by the system. More important, the AIS will be able to provide for the manager this information in a format that this easy to understand, and that can guide future strategy.

Flexibility

One of…

Sources Used in Documents:

References

Barth, M., Cram, D. & Nelson, K. (2001). Accruals and the prediction of future cash flows. The Accounting Review. Vol. 76(1) 27-58.

Friedman, M. (1970) The social responsibility of business is to increase its profits. New York Times Magazine. Retrieved November 19, 2014 from http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html

Hanlon, M. (2005). The persistence and pricing of earnings, accruals, and cash flows when firms have large book-tax differences. The Accounting Review. Vol. 80(1) 137-166.

Investopedia. (2014). Accounting information system. Investopedia. Retrieved November 19, 2014 from http://www.investopedia.com/terms/a/accounting-information-system-ais.asp
Popelka, L. (2013). Too much cash isn't good for Apple. Business Week. Retrieved November 19, 2014 from http://www.businessweek.com/articles/2013-02-26/too-much-cash-isnt-good-for-apple


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