Founded in the early 1980s, the Vermont Teddy Bear Co. designs and manufactures American-made teddy bears and markets them primarily as gifts called Bear-Grams or Teddy Bear-Grams. Bear-Grams are personalized teddy bears delivered directly to the recipient for special occasions such as birthdays and anniversaries. The Shelburne, Vermont, company’s primary markets are New York, Boston, and Chicago. Sales have jumped dramatically in recent years. Such dramatic growth has significant implications for cash flows. Provided below are the cash flow statements for two recent years for the company.

	Current Year	Prior Year
Cash flows from operating activities:
Net income	\( 17,523	\) 838,955
Adjustments to reconcile net income to net cash provided by operating activities
Deferred income taxes	(69,524)	(146,590)
Depreciation and amortization	316,416	181,348
Changes in assets and liabilities:
Accounts receivable, trade	(38,267)	(25,947)
Inventories	(1,599,014)	(1,289,293)
Prepaid and other current assets	(444,794)	(113,205)
Deposits and other assets	(24,240)	(83,044)
Accounts payable	2,017,059	(284,567)
Accrued expenses	61,321	170,755
Accrued interest payable, debentures	-	(58,219)
Other	-	(8,960)
Income taxes payable	-	117,810
Net cash provided by (used for) operating activities	236,480	(700,957)
Net cash used for investing activities	(2,102,892)	(4,422,953)
Net cash (used for) provided by financing activities	(315,353)	9,685,435
Net change in cash and cash equivalents	(2,181,765)	4,561,525
Other information:
Current liabilities	\( 4,055,465	\) 1,995,600
Total liabilities	4,620,085	2,184,386
Net sales	20,560,566	17,025,856

Instructions

1. Note that net income in the current year was only \(17,523 compared to prior-year income of \)838,955, but net cash flow from operating activities was \(236,480 in the current year and a negative \)700,957 in the prior year. Explain the causes of this apparent paradox.
2. Evaluate Vermont Teddy Bear’s liquidity, solvency, and profitability for the current year using cash flow-based ratios.

The cash flow statement is a company's statement prepared at the end of the accounting period that shows the changes in the company's cash and cash equivalents.

Even though the preceding year's income was $821,432 ($838,955 - $17,523) greater than the current year's income, the current year's cash flow from operations was $937,437 greater than the prior year's cash flow from operations [$236,480 - ($700,957)]. This seeming paradox is to be explained by analyzing operating operations' elements of net cash flow. Depreciation and amortization add-back of $316,416 versus $181,348 in the prior year and accounts payable growth of $2,017,059 in the current year versus reduction of $284,567 in the prior year both significantly contributed to the positive cash flow figure in the current year.

The majority of the cash rise can be attributed to the company's substantial increase in accounts payable because an increase in accounts payable leads to an increase in net cash from operating activities. An investor or creditor would want to look into this rise to ensure the business is not behind on payments. It should be noted, though, that inventories did rise by $1,599014.

For current year

Computing Liquidity ratio

$\begin{array}{c}\mathbf{Liquidity}\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{cash}\mathbf{provided}\mathbf{by}\mathbf{operating}\mathbf{activities}}{\mathbf{Average}\mathbf{current}\mathbf{liabilities}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{236}\mathbf{,}\mathbf{480}}{\left[\frac{\left(\$4,055,465+\$1,995,600\right)}{2}\right]}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{078}\mathbf{:}\mathbf{1}\end{array}$

Computing Solvency ratio

$\begin{array}{c}\mathbf{Solvency}\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{cash}\mathbf{provided}\mathbf{by}\mathbf{opearting}\mathbf{activities}}{\mathbf{Average}\mathbf{total}\mathbf{liabilities}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{236}\mathbf{,}\mathbf{480}}{\left[\frac{\left(\$4,620,085+\$2,184,386\right)}{2}\right]}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{070}\mathbf{:}\mathbf{1}\end{array}$

Computing Profitability ratio

$\begin{array}{c}\mathbf{Profitability}\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{cash}\mathbf{provided}\mathbf{by}\mathbf{operating}\mathbf{activities}}{\mathbf{Net}\mathbf{sales}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{236}\mathbf{,}\mathbf{480}}{\mathbf{\$}\mathbf{20}\mathbf{,}\mathbf{560}\mathbf{,}\mathbf{566}}\\ \mathbf{=}\mathbf{1}\mathbf{.}\mathbf{15}\mathbf{\%}\end{array}$

These ratios are all incredibly low. However, this is expected given the early phases of development of a company like the Vermont Teddy Bear Company. A company won't normally produce much net cash flow from operating activities when launching its main product. The company's cash position should be regularly monitored due to the unstable nature of businesses at this point of their development to ensure that it does not enter a financial crisis due to a lack of cash.