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customers, its average inventory holding periods, and so on.
To complete the picture the business has to make certain
planning decisions for the coming year. These key planning
decisions concern capital expenditures, whether to increase its
working cash balance, and whether to pay out cash dividends

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C A P I TA L N E E D S O F G R O W T H


to shareowners. Also the amount of depreciation that will be
recorded in the coming year needs to be calculated. These key
points are summarized as follows:


Planning Decisions for Coming Year

• Note 1. The business prefers to increase its working cash
balance at least $200,000 to keep pace with the increase in
sales growth. At the end of the most recent year its cash
balance was about $2.3 million. I discuss in other chapters
that there is no standard or generally agreed upon ratio
of the working cash balance of a business relative to its
annual sales or total assets or any other point of reference.
This business plans to increase its sales revenue in the
coming year to about $46 million (Figure 7.1). Whether a
$2.3 million working cash balance is sufficient for $46 mil-
lion annual sales is a matter of opinion. Many businesses
would be comfortable with this balance, but many would
not. This business believes that it should increase its work-
ing cash balance at least $200,000, which is shown in Fig-
ure 7.2.
• Note 2. Based on a thorough study of the condition, pro-
ductivity, and capacity of its fixed assets, the business has
adopted a $3 million budget for capital expenditures during
the coming year. (Usually, the board of directors of a busi-
ness must approve major capital outlays for investments in
new long-term operating assets.) The decision regarding
when to replace such items as old machines, equipment,
vehicles, tools is seldom clear-cut and obvious. As a rough
comparison, these business decisions are similar to decid-
ing when to replace your old high-mileage auto with a new
model. Many factors enter into the decisions regarding
replacing old fixed assets of a business with newer models
that may be more efficient and reliable, or that are needed
to expand the capacity of the business.
• Note 3. Depreciation expense increases the accumulated
depreciation account, which is a contra, or negative,
account. Its balance is deducted from the fixed assets
account in which the original cost of property, plant, and
equipment is recorded. An increase in the accumulated
depreciation account means that its negative balance

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A S S E T S A N D S O U R C E S O F C A P I TA L


becomes larger. The amount of depreciation expense for
the coming year will be higher than last year because new
fixed assets costing $3 million will be purchased during the
year. The accounting department calculates the amount of
depreciation expense that will be recorded during the com-
ing year.
Recording depreciation expense does not require a cash
outlay during the year”just the opposite in fact. The cash
inflow from sales revenue includes recovery of part of the
original cost of the business™s long-term operating resources
(recorded in the property, plant, and equipment account).
Therefore the amount of depreciation expense recorded
during a year is added to net income for calculating cash
flow from profit for the coming year. (There are other cash
flow adjustments to net income as well.)
• Note 4. Inventories will increase 14.5 percent, so accounts
payable from inventory purchases on credit should increase
Y
this percent. Also, the accounts payable liability account
FL
includes expenses recorded in the period and that are still
unpaid at the end of the period. This component should
increase 10.6 percent, which is equal to the percent
AM


increase in operating expenses for the coming year. The
increase in accounts payable includes both components.
• Note 5. Income tax payable may change during the coming
TE




year; in any case the increase or decrease is likely to be rel-
atively minor, so a zero change is entered for this liability.
• Note 6. Net income planned for the coming year equals
$2,468,358 according to the profit improvement plan (Fig-
ure 7.1). The board of directors would like to pay $600,000
cash dividends to shareowners during the coming year.
Therefore retained earnings would increase $1,868,358
($2,468,358 net income ’ $600,000 cash dividends to
shareowners).
The forecast changes in operating assets, liabilities, and
retained earnings that are presented in Figure 7.2 provide the
essential information for determining the internal cash flow
from profit for the coming year. Cash flow from profit may not
be all the capital needed for growth, however. The business
probably will have to go to its external sources for additional
capital.
Cash flow from profit (operating activities) during the coming

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C A P I TA L N E E D S O F G R O W T H


year is based on the profit improvement plan and the
increases in operating assets and liabilities forecast for the
coming year. The first section in Figure 7.3 calculates cash
flow from profit, which is then compared with the demands
for capital during the coming year. In this way the amount of
additional capital from external sources is determined.
The business will have to raise almost $1.5 million in exter-
nal capital during the coming year ($1,444,752, to be more
exact). The business™s chief executive working with the chief
financial officer will have to decide whether to approach
lenders to increase the debt load of the business and whether
the business should turn to its shareowners and ask them to
invest additional capital in the business. Of course, these are
not easy decisions. The information in Figure 7.3 is the indis-
pensable starting point.



s
END POINT
Growth is the central strategy of many businesses. Growth
requires that additional capital be secured to provide money




Cash flow from profit (operating activities)
Net income planned for coming year $2,468,358
Accounts receivable increase ($ 594,919)
Inventories increase ($ 835,225)
Prepaid expenses increase ($ 87,227)
Depreciation expense $ 943,450
Accounts payable increase $ 325,108
Accrued expenses payable increase $ 135,703 $2,355,248

Demands for capital
Increase in working cash balance $ 200,000
Capital expenditures budget $3,000,000
Cash dividends to shareowners $ 600,000 $3,800,000

External capital needed during coming year $1,444,752

*Figures 7.1 and 7.2 are sources of above data.
FIGURE 7.3 Cash flow from profit and external capital needed.



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A S S E T S A N D S O U R C E S O F C A P I TA L


for the increases in operating assets needed to support the
higher sales level. Growth penalizes cash flow from profit to
some extent. Generally speaking, a business cannot depend
only on its internal cash flow from profit to supply all the capi-
tal needed for increasing its assets, and therefore it must go to
outside sources of capital.
Based on the profit improvement plan for a business, the
chapter demonstrates an efficient and practical method for
forecasting the amount of capital needed to fuel the growth of
the business and how much will have to come from its exter-
nal capital sources in addition to its projected cash flow from
profit for the coming year.




106
3
PA R T




Profit and Cash
Flow Analysis
8
CHAPTER




Breaking Even and
Making Profit



S
Successful companies are those who year in and year out earn
sufficient profit before interest and income tax from their
operations. Operating earnings is the litmus test of all success-
ful businesses. How do they do it? Not just by making sales
but also by controlling their expenses so that they keep
enough of their sales revenue as operating profit. The long-
term sustainable success of a business rests on the ability of
its managers to earn operating profit consistently. Managers
must know well the pathways to operating profit and avoid
detours along the way.

ADDING INFORMATION IN THE MANAGEMENT
PROFIT REPORT
The main business example used in previous chapters is con-
tinued in this chapter. Figure 8.1 presents the company™s
management profit report for the year just ended”with
important new information presented here for the first time.
The design of this internal accounting profit report copies the
format introduced in Chapter 3. The new items of information
are as follows:
• Total sales volume (number of units) of all products sold
during the period
• The average sales revenue per unit (average sales price per
unit)

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PROFIT AND CASH FLOW ANALYSIS




Sales Volume 578,500 Units
Per Unit Totals
Sales revenue $68.56 $39,661,250
Cost-of-goods-sold expense ($43.15) ($24,960,750)
Gross margin $25.41 $14,700,500
Variable revenue-driven operating expenses ($ 5.27) ($ 3,049,010)
Variable unit-driven operating expenses ($ 4.63) ($ 2,677,875)
Contribution margin $15.51 $ 8,973,615
Fixed operating expenses ($ 5,739,250)
Operating profit $ 3,234,365
Interest expense ($ 795,000)
Earnings before income tax $ 2,439,365
Income tax expense ($ 853,778)
Net income $ 1,585,587
FIGURE 8.1 Management profit report for year just ended, including sales
volume and per-unit values.




• The average product cost per unit (average cost of goods
sold per unit)
• The average variable operating expenses per unit (revenue-
driven and unit-driven)
This additional information is needed for the profit analysis
methods explained in this chapter.
The business has three major product lines and sells dif-
ferent products within each line. The business sells a fairly
large number of different products, which is typical of most
businesses. This chapter looks at the business as a whole,
from the viewpoint of its top executives and board of direc-
tors. The chapter does not probe into profit margin differ-
ences between the business™s product lines and separate
products within each product line. These topics are discussed
in later chapters.

For measuring overall sales activity, businesses in many
industries adopt a common denominator that cuts across all

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