Question

Suppose a friend of yours showed you the pro forma income statements for his start-up and exclaimed excitedly that during the first three years of operations his firm will make a net income of $150,000 per year, which is just the amount of money ($450,000) the firm will need to pay off a three-year loan. Given your study of the chapter, why is it that your friend may not actually have $450,000 in cash, even though his pro forma income statements say that he will earn that amount of money?

Answer 1

Short-version:

income Statement do not represent cashflow thus the 150,000 income is not the equivalent of 150,000 cash

Explanation:

The accounting uses an accrual basis to recognize earnings thus, when a company made a sale or perform their services it will face cycle of collection on these earnigns that will differ with the cycle of payment of the business with their suppliers.

Thus, while there will be an accounting earning of 150,000 our friend should look at the cashflow statement to check for the liquity of his business.

For example ifthe business purchase for 10,000 and sale for 15,000 a gain will be recognize for 5,000

but It will have to purchase stock again o replenish their inventory if it used the whole amount to purchase additional 15,000 inventory

His earnigns will still be 5,000 but available cash to pay their loans will be zero.

Also, is important to understand that these are budgeted situation and will differ to the real-life. This deviancy along with the fact that income do not represent a box with 150,000 cash at the end of the year makes the assumptions of our friend false.