A general contractor is experiencing cash flow problems despite showing profit on the income statement. Which of the following is the most likely cause of this situation?
Correct Answer
C) High accounts receivable and slow collections
Profitable companies can have cash flow problems when revenue is recognized but cash hasn't been collected yet. High accounts receivable with slow collections is the most common cause of this disconnect between profit and cash flow.
Why This Is the Correct Answer
Option A is correct because it illustrates the fundamental difference between accrual accounting (used for income statements) and cash accounting (actual cash flow). When a contractor completes work and bills the client, revenue is recognized immediately on the income statement, showing profit. However, if customers pay slowly or have extended payment terms, the actual cash hasn't been received yet, creating a cash flow shortage despite paper profits. This is the most common cause of profitable companies experiencing cash flow problems in the construction industry.
Why the Other Options Are Wrong
Option A: Overpayment of taxes
Overpayment of taxes would be a one-time cash outflow that could be corrected through refunds or adjustments. This wouldn't create the ongoing disconnect between profitability and cash flow that characterizes the scenario described in the question.
Option B: Understated expenses on the income statement
If expenses were understated on the income statement, the company would actually be less profitable than shown, not more profitable. This would mean the cash flow problems are due to actual losses being hidden, not the timing difference between recognizing revenue and collecting cash.
Option D: Excessive equipment purchases
Excessive equipment purchases would typically show up as capital expenditures and wouldn't necessarily cause a disconnect between profit and cash flow in the same way. Equipment purchases are usually financed or depreciated over time, and while they affect cash flow, they don't create the specific situation where a company shows profit but lacks operating cash.
Memory Technique
Think 'A/R = Already Recorded (but not collected)' - Accounts Receivable represents money you've earned but haven't received yet.
Reference Hint
Business and Finance for Contractors - Chapter on Cash Flow Management and Accounts Receivable
More Business & Finance Questions
A general contractor purchases equipment worth $45,000 with a useful life of 9 years and no salvage value. Using straight-line depreciation, what is the annual depreciation expense?
What is the typical recommended coverage amount for general liability insurance for a small to medium-sized general contracting business?
A contractor estimates startup costs of $75,000 for equipment, $25,000 for initial inventory, $15,000 for insurance premiums, and $10,000 for working capital. They can finance 70% of the total. How much cash do they need?
When establishing professional relationships with architects and engineers, what is the most important factor for a general contractor to consider?
A partnership agreement for a construction company should address all of the following EXCEPT:
A contractor purchases a truck for $60,000. After 5 years, it has accumulated depreciation of $35,000. What is the truck's book value?
A contractor's business plan projects first-year revenue of $500,000 with a 15% net profit margin. If actual revenue is $450,000 with the same profit margin, what is the variance in net profit?
Using the Modified Accelerated Cost Recovery System (MACRS), construction equipment is typically depreciated over how many years?
A contractor is comparing financing options for equipment purchase. Option A: $80,000 cash purchase. Option B: $20,000 down, $65,000 financed at 6% for 4 years. What is the total cost of Option B?
A contractor purchases equipment using a capital lease with a present value of $120,000. How should this be recorded on the balance sheet?