Relations between net income and cash flows. The ABC Company starts the year in tine shape. The firm makes widgets — just what the customer wants. It makes them for $0.75 each and sells them for $1.00. The ABC Company keeps an inventory equal to shipments of the past 30 days, pays its bills promptly, and collects cash from customers within 30 days after the sale.

The sales manager predicts a steady increase in sales of 500 widgets each month beginning in February. It looks like a great year, and it begins that way.

January I Cash, $875; receivables, $1,000; inventory, $750 January In January the firm sells, on account for $1,000, 1.000 widgets costing

$750. Net income for the month is $250. The firm collects receivables outstanding at the beginning of the month. Production equals 1.000 units at a total cost of $750. The books at the end of January show the following:

February 1 Cash. $ 1 . 1 25; receivables. $ 1 ,000; inventory, $750 February This month's sales jump, as predicted, to 1,500 units. With a correspond- ing step-up in production to maintain the 30-day inventory. ABC Company makes 2.000 units at a cost of $1,500. All receivables from January sales are collected. Net income so far is $625. Now the books look like this:

March 1 Cash, $625; receivables. $1,500; inventory. $1,125 March March sales are even better, increasing to 2,000 units. Collections are on time. Production, to adhere to the inventory policy, is 2.500 units. Operating results for the month show net income of $500. Net income to date is

$1,125. The books show the following:

April 1 Cash, $250; receivables, $2,000; inventory, $1,500 April In April, sales jump another 500 units to 2.500, and the manager of ABC Company shakes the sales manager's hand. Customers are paying right on time. Production is pushed to 3.000 units, and the month's business nets $625 for a net income to date of $1,750. The manager of ABC Company takes off for Miami before the accountant's report is issued. Suddenly a phone call comes from the treasurer: "Come home! We need money!"

May 1 Cash, $0; receivables, $2,500; inventory. $1,875

a. Prepare an analysis that explains what happened to ABC Company. (Hint: Compute the amount of cash receipts and cash disbursements for each month during the period January 1 to May 1.)

b. How can a firm show increasing net income but a decreasing amount of cash?

C. What insights are provided by the problem about the need for all three financial statements— balance sheet, income statement, and statement of cash flows?

d. What actions would you suggest that ABC Company take to deal with its cash flow problem'1 36. Balance sheet and income statement relations. (Prepared by Professor Wesley T. Andrews Jr. and reproduced, with adaptation, by permission.)

Once upon a time many, many years ago, a feudal landlord lived in a small province of central Europe. The landlord, called the Red-Bearded Baron, lived in a castle high on a hill. This benevolent fellow took responsibility for the well-being of many peasants who occupied the lands surrounding his castle. Each spring, as the snow began to melt, the Baron would decide how to provide for all his serf dependents during the coming year.

One spring, the Baron was thinking about the wheat crop of the coming growing season. "1 believe that 30 acres of my land, being worth five bushels of wheat per acre, will produce enough wheat for next winter," he mused, "but who should do the farming? I believe I'll give summoned [van and Igor, two gentry noted for their hard work and not overly active minds, for an audience.
'Ivan, you will farm on the 20-acre plot of ground, and Igor will farm the 10-acre plot." the Baron began. '*! will give [van 20 bushels of wheat for seed and 20 pounds of fertilizer. (Twenty pounds of fertilizer are worth two bushels of wheat.) Igor will get 10 bushels of wheat for seed and 10 pounds of fertilizer. I will give each of you an ox to pull a plow, but you will have to make arrangements w ith Feyador. the Plow maker, for a plow. The oxen, incidentally, are only three years old and have never been used for farming, so they should have a good 10 years of farming ahead of them. Take good care of them, because an ox is worth 40 bushels of wheat.
Come back next fall and return the oxen and the plows along with your harvest." Ivan and Igor bowed and withdrew from the Great Hall, taking w ith them the things provided by the Baron.
The summer came and went. After the harvest Ivan and Igor returned to the Great Hall to account to their master for the things given them in the spring. Ivan, pouring 223 bushels of wheat onto the floor, said. "My Lord. I present you with a slightly used ox. a plow broken beyond repair, and 223 bushels of wheat. I. unfortunately, owe Feyador. the Plowmaker. three bushels of wheat for the plow I got from him last spring. And. as you might expect. I used all the fertilizer and seed you gave me last spring. You will also remember, my Lord, that you took 20 bushels of my harvest for your own personal use." Igor, who had been given 10 acres of land. 10 bushels of wheat, and 10 pounds of fertilizer, spoke next. "Here, my Lord, is a partially used-up ox. the plow for which I gave Feyador. the Plowmaker. three bushels of wheat from my harvest, and 105 bushels of wheat. I. too, used all my seed and fertilizer last spring. Also, my Lord, you took 30 bushels of wheat several days ago for your own table. I believe the plow is good for two more seasons."
'"Knaves, you did well," said the Red-Bearded Baron. Blessed with this benediction, the two serfs departed. After the servants had taken their leave, the Red-Bearded Baron, watching the two hungry oxen slowly eating the wheat piled on the floor, began to contemplate what had happened. "Yes." he thought, "they did well, but I wonder which one did better'1"

a. What measuring unit should the Red-Bearded Baron use to measure financial position and operating performance?

b. Prepare a balance sheet for Ivan and for Igor at both the beginning and the end of the period.

c. Prepare an income statement for Ivan and for Igor for the period.

d. Prepare a schedule reconciling the change in owner's equity between the beginning and the end of the period.

e. Did Ivan or Igor perform better during the period? Explain.