Question

1. Myron apparently thought that high profits guaranteed adequate cash to pay any bills as they came due. Explain to Myron the difference between Net Income and Cash Flow. In particular, explain how even a profitable, highly efficient firm can experience cash crunches and have a need for outside capital

2. In an attempt to encourage dealers to pay sooner, Myron offered terms of 2/10 net 90. Do you find it surprising that only 10% of his customers took advantage of the discount and paid within 10 days? Defend your answer.

Answer 1

QUESTION 1

Net Income of a company indicates whether the company has made profit during a period. Net Income is arrived by deducting depreciation, amortization, general expenses from Total Revenue. Net Income does not take into account the changes in net working capital. Net Income is generally regarded as a measure of profitability and is basically looked by investors and lenders to determine the financial soundness and creditworthiness of the company.

Whereas, Cash Flow refers to what is left for a firm after paying out all the expenditures incurred during a period. In financing a project, the prime concern is estimation of project cash flows. It is to determine whether the project will be able to recoup the initial investment made and generate profit over the course of its life.

Cash Flow = Cash Profit – Capex – Changes in Net Working Capital + Depreciation.

Profitable and Highly efficient firms have cash crunches and have a need for outside capital due to the following reasons:

The prime reason being the firm have tax payments, loan payments, dividend payments and all other expenses to meet with the profit generated during the year. In addition to that, company maintain a portion of their profit as retained earnings for the next year and a reserve is maintained to meet unforeseen contingencies. After these adjustments, amount of profit available will shrink. Furthermore, a portion of sales can be on credit.

In this situation, the firms don’t receive liquid cash, instead it is considered as bills receivable. And, majority of profit will either be invested in fixed assets or stocks. Hence, firms generally have limited cash with them. Hence, for firms to carry out expansion to foreign markets, new product development, investment in R&D, they have to depend on outside capital.