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IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information

A profitable company reports steadily rising profit after tax, but its net cash from operating activities has been falling for three years, mainly because trade receivables are growing faster than sales. Which interpretation is most appropriate?

Earnings quality may be weakening. Profit is being recognised on credit sales that are not collected, so operating cash flow falls while profit rises, raising the risk of bad debts and liquidity strain.

  1. AEarnings quality may be weakening, with a risk of bad debts and liquidity strainCorrect
  2. BProfitability is improving and liquidity is therefore also improving
  3. CThe company is overstating depreciation
  4. DThe company is accumulating cash from customers early
  5. Financing cash flows must be negative

Explanation

Receivables growing faster than sales means profit is recognised but cash is not collected, lowering operating cash flow. This signals weaker earnings quality, collection risk and possible liquidity pressure. The other options contradict the facts.

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