Max Stevenson owns a local drug store. During the past few years, the economy has experienced 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 profit 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 the company can have income of $60,000 yet he and the company still have a shortage of cash.