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If a business is filing their taxes on accrual basis and…

hello. If a business is...
hello. If a business is filing their taxes on accrual basis and their income statement is filed on accrual basis, what is the best way to verify the true cash flow of the business? example, window replacing business with hundreds of residential and commercial customers (10M/year in gross sales)as we know, everything can look good on accrual basis but the business could be on it's way to insolvency.
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Answered in 3 minutes by:
1/11/2018
Mark Taylor
Mark Taylor, Certified Public Accountant (CPA)
Category: Finance
Satisfied Customers: 2,397
Experience: Certified Public Accountant
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Hi, my name is Mark. I will be happy to help you with your question. There is a statement of cash flows that considers your change in cash in the current period, your operating income or loss, and your changes to assets and liabilities.

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Customer reply replied 1 month ago
Sorry I should have expressed my question better. What I meant is after looking at the CF statement what is the best way to verify the true CF of the business. The actions that need to be taken to verify the CF short of doing a full quality of earnings report.

I apologize. I misunderstood. There is the quality of income ratio. The ratio is determined by Cash flow from operating activities divided by net income.

A quality of income ratio higher than 1 is an indication of high quality earnings, while the ratio lower than 1 is considered to indicate low quality earnings.

Accrual earnings as you mentioned do not necessary reflect cash flows. As the result, the quality of income ratio is as follows: high quality earnings should reflect the cash flows (from operations) of the organization. If each dollar of income is supported by one dollar or more of cash flow from operations, then such income has a high quality.

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Customer reply replied 1 month ago
I'm looking at a business to purchase and i'll want to make sure the financials are correct. I want to verify that the cash flow shown on the CF statement truly exists. I wouldn't want to spend 20k+ on a quality of earnings report (maybe later in the process) but i'd like to do some due diligence
Customer reply replied 1 month ago
understood.. so one would ask for bank statements to show distributions to owner? match random invoices from GL to bank account inflows of money?..

Please give me a moment. I am tied up on a phone call.

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Customer reply replied 1 month ago
no problem, i'm not in a hurry

Here are some items that you would want to request.

Bank Statements - you would want to compare the total deposits to the income statements. You would also need to look at the change in accounts receivable to determine it coincides with the sales amount.

Do you know if there are any large customers? Are the companies revenues generated by a few large customers?

I would request a detailed general ledger (electronic version)

If you are matching invoices to the GL you would want to select the larger invoices. This way you can select fewer invoices and verify a larger percentage. If there are problems you can select more to test.

You would want also to do a horizontal analysis of the balance sheet and income statement. A Horizontal analysis looks at the changes from one period to the next. You would want to look at the significant changes. Let me give you an example. Let's say that accounts receivable tripled from one period to the next but sales only increased by 10%. If this is the case I would question the quality of the earnings. Did the company relax their credit policy? Is there a collection problem? Will you get paid for these funds?

Of course this depends on what type of purchase it will be? Is it a stock purchase or an equipment purchase?

Mark Taylor
Mark Taylor, Certified Public Accountant (CPA)
Category: Finance
Satisfied Customers: 2,397
Experience: Certified Public Accountant
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Customer reply replied 1 month ago
sorry i was out of town with no access to internet for a few days.
the business would be an asset purchase.
and it has 6 large customers about 15%-20% each
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