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Evolution of a Company (Part Two) 1 Dr. Craig Ruff Department of Finance J. Mack Robinson College of Business Georgia State University © 2014 Craig Ruff.

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Presentation on theme: "Evolution of a Company (Part Two) 1 Dr. Craig Ruff Department of Finance J. Mack Robinson College of Business Georgia State University © 2014 Craig Ruff."— Presentation transcript:

1 Evolution of a Company (Part Two) 1 Dr. Craig Ruff Department of Finance J. Mack Robinson College of Business Georgia State University © 2014 Craig Ruff

2 2 As the sole owner of the company, what is Derrick’s wealth as of Feb 30 th ? Balance Sheet: February 30 Common Stock$400,000 Retained Earnings$50,000 A/R$150,000 Inv.$120,000 Cash$180,000 Total $450,000 Assets Total Liab.$450,000 And Equity © 2014 Craig Ruff

3 3 One answer might be that he is worth $450,000, which is the book value of the owner’s equity (the common stock plus the retained earnings). Balance Sheet: February 30 Common Stock$400,000 Retained Earnings$50,000 A/R$150,000 Inv.$120,000 Cash$180,000 Total $450,000 Assets Total Liab.$450,000 And Equity

4 4 A/R$150,000 Inv.$120,000 Cash$180,000 Is he really worth 450,000 dollars? Wouldn’t it be more accurate to say that he is really worth 180,000 dollars, $150,000 in money that is owed to him by his customers, and a bunch of golf balls that are on the books at $120,000. Suppose Derrick just learned that his major customer (who represents the largest chunk of the accounts receivables) has just declared bankruptcy. Now what are those receivables worth? What if a competitor suddenly introduces a far superior golf ball that sells for a much lower price. Is his inventory still worth $120,000?

5 5 But can we not take this further and say that what Derrick is really worth is the price for which he could sell the company? A person buying the company would certainly be interested in the cash, the accounts receivable, and the inventory. Arguably, though, the price of the company would mainly be based on the potential future profits from the company, and those potential profits are based on so much more than what is ‘on the books,’ such as the existing customer base, the company’s reputation in the community, the quality of its product, the quality of the business concept, etc. What someone would buy the company for is its market value. It is, generally, a forward looking number. The equity value on the balance sheet is the book value. That is largely a historically based number. © 2014 Craig Ruff

6 6 Before we move on, in a previous slide, I state that Derrick is “really worth 180,000 dollars, $150,000 in money that is owed to him by his customers, and a bunch of golf balls that are on the books at $120,000.” Would it be better if the left-hand-side of his balance sheet were all cash? In other words, is Balance Sheet A better than Balance Sheet B? Cash $450,000 Common Stock $400,000 Retained Earnings $50,000 Balance Sheet ABalance Sheet B Cash $180,000 Common Stock $400,000 A/R $150,000 Retained Earnings $50,000 Inv. $120,000 Well, there is the old expression that ‘cash is king.’ But the reality is that Derrick cannot run a business when his only asset is cash. Having all of the assets in cash is nice if Derrick wants to liquidate the business; however, as it is an ongoing business, other assets are needed.

7 7 A final point is that there is no retained earnings bank account. It is not as though the company takes the income that it does not pay out as dividends and deposits the money in the bank. Instead that $50,000 in retained earnings is invested in the firm’s cash, accounts receivable, and golf balls. As money is fungible, it is not clear what are the proportions. Balance Sheet February 30 th Cash $180,000 Common Stock $400,000 A/R $150,000 Retained Earnings $50,000 Inv. $120,000

8 8 The final point is that the assets did not appear out of thin air. The left hand side needs the right hand side. Balance Sheet February 30 th Cash $180,000 Common Stock $400,000 A/R $150,000 Retained Earnings $50,000 Inv. $120,000

9 9 To continue on with the story, Derrick’s sales continue to increase. In March, his sales are 50,000. And his cash drops to $50,000 by the end of March. In April, his sales are 70,000. And, given our assumptions, his cash balance would hit zero sometime during the month. Clearly, it is not possible for Derrick to run his business without cash. It is unlikely that his employees and suppliers will want to be paid in golf balls. Big Point: Net income does not equal cash flow.

10 10 What happened? How did a profitable and growing company end up running out of cash? In this case, the key word is ‘growing.’ The simple answer is that as the sales increase, accounts receivable and the inventory are spontaneously growing along with the sales. And even though the firm is not paying any dividends, the income of the firm is still not sufficient to support the growth in accounts receivable and the inventory. Instead, the firm is gradually drawing down cash to pay for the increased inventory and the firm’s increased ‘lending’ of money to its customers.

11 11 Balance Sheet: January 1 Cash $400 Common Stock $400 Balance Sheet: April 30 Cash ???? A/R $350 Inven. $280 Total $570 Common Stock $400 Retained Earnings $170 Total $570 On January 1, cash was $400,000. Sometime in April, the firm runs out of cash. Over this period, we can see that the cash on the balance sheet (along with the company’s income) has been transformed by the day-to-day transactions of the business into accounts receivables and inventory.

12 12 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… Derrick could reduce the inventory he holds. Ceteris paribus… Cash ↑ Inventory ↓

13 13 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… Derrick could collect faster from his customers, which would reduce his accounts receivable. Ceteris paribus… Cash ↑ AR ↓

14 14 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… Derrick could borrow money from the bank. Ceteris paribus… Cash ↑ Debt ↑

15 15 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… Derrick could ‘issue more stock’ by bringing in other equity investors or putting in more of his money. Ceteris paribus… Cash ↑ Common Stock ↑

16 16 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… Instead of paying his suppliers immediately, Derrick could delay paying them, which would create accounts payable. Ceteris paribus… Cash ↑ Accts. Payable ↑

17 17 With a little planning, Derrick can find ways out of his running-out-of-cash dilemma… There are other strategies. For instance, Derrick could raise his prices which might slow his sales growth while perhaps increasing his net income. Or, Derrick could sell his receivables (at a discount) to a bank for cash. The big point is that there are a variety of things that Derrick could do alleviate his cash problem; however, he must be looking and planning ahead so that he is not forced into crisis-based decision making.

18 18 End


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