Purpose: To help you understand the importance of cash flows in the operation of a small business.
The end of the year is approaching. You’re going to meet with your CA next week to do some end-of-the-year tax planning, so in preparation for that meeting you look at your last month’s income statement. You know that you've had a pretty good year, which means that you’re going to have to pay some income taxes. But you know if you can get your taxable income down, you won’t have to pay as much in income taxes.
You remember that one of your suppliers was offering a pretty good discount if you purchased from the company in bulk. The only problem is you have to pay for the purchases at the time of purchase. Knowing that you want to decrease your taxable income, you call up the supplier and place a large order and write the supplier a cheque.
At your meeting with the CA, you tell of the large inventory purchase for cash that you just made and how much income tax that will save you on this year’s income tax return. The CA has a rather troubled look on his face; that look usually means you’ve made some kind of an error. So you pose this question to him:
“Steve, you got that look on your face right after I told you about the big inventory purchase that I made. Even though I used up a lot of my available cash, the reason I did it was to save money on my tax return. A big purchase like that has to knock down my taxable income pretty good, huh? And besides, I got these products for a really good price, which means I’ll make more profit when I sell them. So why do you have that look? Did I mess up?”
Requirement
If you were the CA, how would you respond to this client? Is the large inventory purchase going to have any effect on his income statement? What about the fact that he paid for this large purchase in cash? Was that a good idea to use a large portion of available cash for a purchase like this? Keeping in mind that inventory can have a significant amount of carrying cost (storage, personnel, opportunity cost of the money, etc.) would you tell your client that this was a good thing that he did, or not?