Question

Eli Lilly is very excited because sales for his nursery and plant company are expected to double from \(600,000 to \)1,200,000 next year. Eli notes that net assets (Assets - Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. 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 in profit.

Short answer

The optimistic outlook for the cash position is not correct because the company is facing cash deficit problem. The cash deficit for the end of the year is $84,000.

Step-by-step solution

Purchases of assets

$\begin{array}{rcl}\mathrm{Assets}\mathrm{purchased}& =& \left(\mathrm{Expected}\mathrm{sales}-\mathrm{Current}\mathrm{sales}\right)\times 50\%\\ & =& \left(\$1,200,000-\$600,000\right)\times 50\%\\ & =& \$300,000\end{array}$

Expected Profit earned

$\begin{array}{rcl}\mathrm{Profit}\mathrm{earned}& =& \mathrm{Expected}\mathrm{sales}\times \mathrm{Rate}\mathrm{of}\mathrm{return}\\ & =& \$1,200,000\times 8\%\\ & =& \$96,000\end{array}$

Cash balance at the end of the year

Particulars	Amount (S)
Opening cash balance	120,000
Add: Profit earned	96,000
Less: Assets purchased	(300,000)
Closing Cash Deficit	(84,000)

The company is not correct in adopting the optimistic outlook, as the cash balance is negative.