(i) Eli Lilly is very excited because sales for his nursery and plant company are expected to double from $600,000 to $1,200,000 next year. Eli notes that net assets (Assets — Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. Does his optimistic outlook for his cash position appear to be correct? Compute his likely cash balance or deficit for the end of the year. Start with beginning cash and subtract the asset buildup (equal to 50 percent of the sales increase) and add in profit. (ii) In problem 1 if there had been no increase in sales and all other facts were the same, what would Eli’s ending cash balance be? What lesson do the examples in problems 1 and 2 illustrate?
(i) The calculation starts with the beginning cash which is subtracted the asset buildup and then added in profit. As to why subtract the asset buildup? This is because the calculation should be working with net assets (assets and liabilities), which is short for “assets not financed with debt”. Because any asset not financed with debt in reality must be funded either with fresh equity or with retained earnings, the total $300,000 increase in assets needs to be supported by an increase in debt (Jensson, 2006).
Beginning cash $120,000
Asset buildup (300,000) (50%* $1,200,000)
Profit 96,000 (8%* $1,200,000)
Ending cash ($84,000) Deficit
Therefore, his optimistic outlook for his cash position is wrong. Cash will be in a deficit.
(ii) In problem 1 if there had been no increase in sales and all other facts, the new calculation is shown below.
Beginning cash $120,000
Asset buildup (0)
Profit 48,000 (8%* $600,000)
Ending cash $168,000 Balance
Therefore, even though no increase in sales, Eli Lilly would end up with cash balance but not deficit.
From the examples in problem 1 and 2, we can learn the lessons that higher sales may not translate into higher cash flow. The more sales obtain, the more financing requirements needed (Dechow et al., 1998). For example, the cash may be used for building up inventories, which may depreciate in value or even become obsolete if the inventories are not sold in a timely manner. Inventories are valued as assets since they tie up capital; hence they are expected to be sold as soon as possible so that realizing investment return. The expenses of building up inventories are not recorded until products are actually sold. Inventories become liabilities when life cycle ends either because of expiry or by becoming discounted/ obsolete (Buzacott & Zhang, 2004).
In problem 1 even though the company’s sales are expected to double, the assets remain 50% of the increased sales, which leads to significant cash reduction even for a potential profitable firm. In order to ensure cash balance, Eli Lilly should try to sell the liquid assets such as inventories as soon as possible. On the other hand, because the sales keep the same in problem 2, there is no more capital needed to build up assets. All in all, increasing sales not necessarily lead to more cash balance.
Buzacott, J. A., & Zhang, R. Q. (2004). Inventory management with asset-based financing. Management Science, 50(9), 1274-1292.
Dechow, P. M., Kothari, S. P., & L Watts, R. (1998). The relation between earnings and cash flows. Journal of Accounting and Economics, 25(2), 133-168.
Jensson, P. (2006). Profitability Assessment Model. Reykjavík, Iceland.