Salamah Hijazi, an Egyptian immigrant, founded The Lavender Soap Company (LSC) in Seattle at the end of X1 with a capital at par of $60,000. The business mission of Lavender

Soap was to distribute organic soaps, cleansing and beauty products both in retail stores located in shopping malls, and wholesale to corporate clients such as hotels and cruise ship operators (Seattle is home port for 11 large cruise ships per week during the six months sailing season to

Alaska). The business started operations on 1 January X2.

Sales in X2 were both to retail customers (40 percent of net sales revenue, but providing 50 percent of the total gross margin) and to ‘wholesale’ clients (60 percent of net sales revenue and providing 50 percent of total gross margin). LSC does not operate a web-based market place at this time but is considering creating one soon. 

So far, LSC operates only one store, located in South Center Mall, a middle class mall in suburban Seattle. The owner-manager is intent on growing the business and is looking for additional locations to open new stores. A possible store front will become available in mid-March X3 at the upscale brand-new Bravern Shopping Center in Bellevue, a very wealthy eastern suburb of Seattle, some ten miles to the north of South Center Mall. Salamah Hijazi has obtained the right of first refusal. A prompt decision on this opportunity is thus required on his part, or another retailer will snap up the storefront and no new desirable opportunities appear to be in the making, despite the economic slowdown in the region.

Opening this new store would require acquiring the leasehold for $45,000 cash, acquiring furniture and fixtures for another $55,000, which would probably have to be paid in cash, and the decoration of the store would require an additional $25,000 cash payment. The minimum starting inventory for the store would be worth about $58,000. The new store would open toward the very beginning of the second quarter of X3.

The results for the operations of the fourth quarter X2 were as follows (Q4 X2 is considered a ‘normal’ quarter, after three losing quarters – accumulated losses as of the end of Q3 X2 were $28,300 – for the sake of simplicity in this exercise, past losses cannot, unlike in the real world, be used to offset current or future earnings):

Sales revenue Sales revenue Gross margin Cost of selling (rent, procurement, sales force, etc.) Cost of administration (manager, accountant, etc.) Financial expenses (on a three-year loan of $133,000 at 6%) Income before tax Minus income taxes (net rate of 30%) Net income after taxes

208,000 105,000 103,000 35,000 5,000 2,000 61,000 18,300 42,700

1 Salamah Hijazi expects sales at the South Center Mall store (which, he feels, has not yet reached its full potential) to increase by 10 percent in each of the next two quarters (early X3). Wholesale business is expected to grow, hopefully, by 5 percent per quarter for at least two quarters.

2 Retail sales are paid cash or by credit or debit cards (essentially equivalent to cash for the purpose of this mini-case). Wholesale sales are collected two months after delivery and invoicing. The balance in accounts receivable at the end of X2 is thus expected to be about $84,000. 

3 Purchases of merchandise-for-sale in the fourth quarter X2 are expected to approximate $96,000. 

4 Purchases are paid to suppliers within a month after receiving the goods. Accounts payables at the end of the fourth quarter X2 are expected to stand at $32,000.

5 The ending inventory (of sellable merchandise) at the end of X2 is expected to be $82,500. The policy of LSC is to aim for inventory on hand at any time to be approximately equal to three-quarters of the cost of merchandise expected to be sold in the subsequent three months.

6 An advertising campaign is planned for early X3 to promote the South Center Mall store after the holy day period, and thus avoid any seasonal effect on sales revenue. This advertising campaign will cost about $8,000. All other selling and administrative expenses are expected to be about the same per quarter, for at least the next two quarters (excluding any additional expenses due to the new store). All expenses, including interest expenses, other than purchases of merchandise for sale are paid cash in the quarter incurred.

7 Selling expenses include a depreciation expense of $5,000 for the depreciation of the store’s furniture and fixtures, computerized cash register, and phone and credit card electronics (which have a gross historical cost of $60,000 and will have a net book value of $40,000 at the end of X2) Administrative expenses include a depreciation expense of $1,700 for office furniture, computer and information technology equipment. These assets have a gross historical cost of $34,000 and will have a net book value of $27,200 at the end of X2.

9 The income tax rate, starting in X3, is expected to remain at 30 percent of taxable income and remain at that level in the foreseeable future. Taxes are paid in the quarter following (i.e. taxes on income of Q4 X2 would be paid in Q1 of X3).

10 The cash balance at the end of X2 is expected to be $24,000.

Required

Assuming LSC wishes to have at least $25,000 in cash (or cash equivalents) on hand at the end of the first quarter of X3, can the new store be opened without obtaining external funds? What questions would you raise to know whether or not the new store in the Bravern Shopping Center should be opened? 

To answer the first part of the question, you need to prepare both a pro forma or budgeted statement of cash flows and a pro forma or budgeted income statement for the first quarter of X3. Should you need external funding, the financial institution would also require LSC to provide a pro forma or budgeted balance sheet as of the end of Q1 X3.