Cash Flow Versus Profit in a Growing Business
A sole trader's income statement for the year shows profit of $62,000. During the year, accounts receivable rose from $14,000 to $31,000, inventory rose from $22,000 to $38,000, accounts payable rose from $11,000 to $16,000, and the owner withdrew $45,000. Equipment costing $30,000 was purchased for cash, and a loan of $20,000 was received. The bank balance fell from $9,000 to $2,500. The owner cannot understand how a profitable year produced a falling bank balance and is considering taking a further $10,000 for a personal purchase.
1. Reconcile profit to the change in the bank balance and explain the main drivers.
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Start with profit $62,000. Deduct the increase in receivables $17,000 (sales earned but not collected). Deduct the increase in inventory $16,000 (cash spent building stock). Add the increase in payables $5,000 (expenses incurred but not paid). This gives cash from operations of $34,000. Deduct equipment purchase $30,000 and drawings $45,000, and add loan proceeds $20,000, giving a net decrease of $21,000. Opening bank $9,000 less $21,000 would be negative, so the figures imply the owner must also have contributed capital or sold an asset; with the data given, the closing position is consistent with a fall of $6,500 only if other inflows of $14,500 exist. The key drivers are the large increase in receivables and inventory absorbing cash, and drawings exceeding operating cash flow.
2. Advise the owner on whether the further $10,000 withdrawal is prudent, giving reasons.
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It is not prudent. Operating cash flow of $34,000 is already less than drawings of $45,000, so the owner is funding personal spending partly from the loan, which increases liabilities without generating returns. A further $10,000 would push drawings well beyond the cash the business generates, leaving only $2,500 in the bank and risking an inability to pay suppliers or repay the loan. The owner should first improve cash conversion - tighten credit collection on the $31,000 receivable, reduce inventory holding, and negotiate supplier terms - before increasing drawings. Drawings reduce equity and are not an expense, so they do not reduce profit, which is why the owner's confusion is understandable but the decision would still be financially damaging.