Philip Morris is very excited because sales for his clothing company was expected to double from $500,000 to $1,000,000 next year. Philip notes that net assets (assets – liabilities) will remain at 50 percent of sales. His clothing firm will enjoy a 9 percent return on total sales. He will start the year with $100,000 in the bank and is bragging about the two Mercedes he will buy and the European vacation he will take. 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 profit.

This is the answer:
Beginning cash $100,000
 Asset buildup (250,000) (1/2 × $500,000)
Profit 90,000 (9% × $1,000,000)
Ending cash ($60,000) Deficit
No. Cash will be in a deficit.

What I don't get is... why subtract asset buildup. What is that. It's not related to cash! It probably is really simple but I don't understand. Thanks

I am not familiar with the term "asset buildup." Given that they want you to subtract it from cash, I'm suspecting that it's meaning like saving up for assets. So that would indeed be setting aside cash (possibly in some investments).

And Mr. Morris is going to go broke having that attitude anyway. LOL.

I think the key is the fact that you're working with net assets, which is shorthand for "assets not financed with debt".

Any asset not financed with debt must be funded either with fresh equity, or with retained earnings (which is just a special case of fresh equity, anyway).

Thus you have here an expectation of net assets increasing by 250K. Doesn't matter what total asset growth there'll be--it's sufficient that we know that all but 250K of the asset growth will be supported by an increase in debt.

That leaves us looking for 250K to come from earnings or new equity. Now we see that the earnings expectation is only 90K. Given that there's only 100K in the kitty at the start of the year, the shortfall becomes obvious.

Morgaine is right... Philip Morris' attitude is a bit premature. His sales will tank once his customers realize that everything in his shop smells of cigarette smoke :p

Cheers, all

OK I think I get it. Thanks for the answers everyone!:p

Quote:

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Originally Posted by arcsine

morgaine is right...philip morris' attitude is a bit premature. His sales will tank once his customers realize that everything in his shop smells of cigarette smoke :p

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Rotfl!