Question

Scenario

Katherine Potter knew a good thing when she saw it. At least, it seemed so at first. She was traveling in Italy when she spotted pottery shops that made beautiful products ranging from ashtrays to lamps. Some of the pottery was stunning in design.

Katherine began importing the products to the United States, and sales took off. Customers immediately realized the quality of the items and were willing to pay top price. Katherine decided to keep prices moderate to expand rapidly, and she did. Sales in the second three months were double those of the first few months. Sales in the second year were double those of the first year.

Every few months, Katherine had to run to the bank to borrow more money. She didn’t really discuss her financial situation with her banker because she had no problems getting larger loans. You see, she always paid promptly. To save on the cost of buying goods, Katherine always took trade discounts. That is, she paid all bills within 10 days to save the 2% offered by her suppliers for paying so quickly.

Most customers bought Katherine’s products on credit. They would buy a couple of lamps and a pot, and Katherine would allow them to pay over time. Some were very slow in paying her, taking six months or more.

After three years, Katherine noticed a small drop in her business. The local economy was not doing well, and many people were being laid off from their jobs. Nonetheless, Katherine’s business stayed level. One day, the bank called Katherine and told her she was late in her payments. She told them she had been so busy that she didn’t notice the bills. The problem was that Katherine had no cash available to pay the bank. She frantically called several customers for payment, but they were not able to pay her, either. Katherine was in a classic cash flow bind.

Katherine immediately raised her prices and refused to make sales on credit. She started delaying payment on her bills and paid the extra costs. Then she went to the bank and went over her financial condition with the banker. The banker noted her accounts receivable and assets. He then prepared a cash budget and loaned Katherine more money. Her import business grew much more slowly thereafter, but her financial condition improved greatly. Katherine had nearly gone bankrupt, but she recovered at the last minute.

Questions:

1 How is it possible to have high sales and high profits and run out of cash?

2 Why did Katherine do better when she raised her prices and refused to sell on credit?

3 What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even though she owed the bank money? How could she have prevented some of the problems she eventually found herself faced with?

Answer 1

Answer to

1. How is it possible to have high sales and high profits and run out of cash?

That is the classic description of a poor cash flow. A firm sells lots of merchandise on credit and buys more, paying promptly. Credit sales are great, and the firm buys more merchandise on credit. One day the creditors ask for money, and the firm cannot collect its accounts receivable fast enough; it is cash poor. It could go bankrupt if it can’t borrow money someplace to cover until accounts receivable are collected.

2. Why did Katherine do better when she raised her prices and refused to sell on credit?

Higher prices increase cash flow when the terms are cash and slow the need to borrow funds to buy on credit. Too rapid growth often leads to cash flow problems because the growth is all financed and there is not enough cash available to back it up.

3. What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even though she owed the bank money? How could she have prevented some of the problems she eventually found herself faced with?

Katherine had a classic cash flow problem, and, yes, a bank is an excellent place to turn for help. The bank can provide funds, help in designing a cash budget, and provide further guidance to avoid cash flow problems in the future. What got Katherine in trouble in the first place was being too free to grant credit to customers and not being more insistent about collecting overdue accounts. To slow business, she could have raised prices and given credit only to her best customers.