Max Stevenson owns a local drug store. During the past few years, the economy has been experiencing a period of high inflation. Stevenson has had the policy of withdrawing cash from his business equal to 80% of the company's reported net income. As the business has grown, he has had a CPA prepare the company's financial statements and tax returns. The following is a summary of the company's income statement for the current year:
Revenue $565,000
Cost of goods sold (drugs, etc) 395,000
Gross pofit on items sold 170,000
Operating expenses, including taxes 110,000
Net income 60,000
Even though the business has reported net income each year, it has experienced severe cash flow shortages. The company has had to pay higher prices for its inventory as the company has tried to maintain the same quantity and quality of its goods. For example, last year's cost of goods sold had a historical cost of $250,000 and a replacement cost of $295,000. The current year's cost of goods sold has a replacement cost of $440,000,. Stevenson's personal cash outflows have also grown faster than his withdrawals from the company due to increasing personal demands.
Stevenson asks you as a financial advisor how can the company have income of $60,000 yet he and the company still have a shortage of cash?
The company's income statement shows a net income of $60,000, which means that the company's expenses were less than its revenue by that amount. However, despite this positive net income, Max Stevenson and the company still experience a shortage of cash. There are several factors that could contribute to this situation based on the information provided.
1. Cash Withdrawals: Stevenson has a policy of withdrawing cash from the business equal to 80% of the company's reported net income. This means that he takes out a significant portion of the net income for personal use, leaving less cash available for the company's operations.
2. High Inflation: The economy has been experiencing a period of high inflation, which means that the prices of goods and services are increasing. The company has to pay higher prices for its inventory (Cost of Goods Sold) while trying to maintain the same quantity and quality of goods. This increase in costs reduces the available cash for other expenses.
3. Operating Expenses: The company has operating expenses, including taxes, of $110,000. These expenses need to be paid for out of the company's cash reserves, further reducing the available cash.
4. Personal Cash Outflows: Stevenson's personal cash outflows have grown faster than his withdrawals from the company due to increasing personal demands. This means that his personal expenses are growing and he may require more cash from the company to meet his personal obligations, further depleting the company's cash reserves.
In summary, while the company may have a positive net income, the combination of cash withdrawals, high inflation, operating expenses, and Stevenson's personal cash outflows can lead to a shortage of cash for the company's operations. It is important for Stevenson to manage his personal expenses effectively and consider reinvesting more of the net income back into the company to alleviate the cash flow shortages. Additionally, the company may need to explore strategies to mitigate the impact of inflation, such as adjusting pricing or seeking more favorable supplier contracts.