Cash: Austin’s Cycle Shop
A few years ago, Austin opened his own bicycle sales and service shop— called Austin’s Cycle Shop. He determined that he needed $50,000 to get up and running, so he used money from his own savings and borrowed money from a bank and a private investor, his brother-in-law. Start-up costs – his store lease, professional fees, licenses, furnishings for the store, inventory (bikes and parts), and equipment – were $40,000. He put the remaining $10,000 in the bank as a safety net for the early months when sales and revenue might be shaky. So his initial cash position was $10,000.
But during the first year, Austin collected $70,000 from selling and servicing bicycles. He also had expenses of $55,000 (he took a very small salary that first year). So how much cash did he generate from his operations? What was his cash flow? Right, $15,000. He never touched his initial cash reserves, so at the end of year 1, he had a total cash position of $25,000 ($10,000 cash position + $15,000 cash flow).
Austin had choices in what to do with the $25,000 cash he had at the end of his first year. He could put the entire $25,000 in the bank for maximum liquidity. Or he could use part or all of it in investing activities; such as remodeling the building, making a down payment on a truck, or buying stocks or mutual funds for a greater return than his savings account offered. Or he could use it in financing activities; such as paying back part of his bank loan or repaying his investor. But Austin decided that for maximum safety and liquidity, he would keep all of his $25,000 cash balance at the end of his first year in the bank. He had done well in the first year, but you never know when a competitor might open up across the street or a piece of equipment might break.
In his second year, he received $100,000 in cash from sales and spent $80,000 in operating his business, so he generated $20,000 in cash flow. With higher cash flow in his second year of business, Austin decided to start using his cash. He paid back a portion of his bank loan, he bought a used truck so that he could offer to pick up and deliver customers’ bikes, and he bought out his brother-in-law’s investment. His brother-in-law was supposed to be a silent investor, but it didn’t quite turn out that way and Austin was getting tired of the stream of advice he was getting during holiday meals.
Austin could have used even more than $15,000 cash in nonoperational activities. He still had a cash position of $30,000. He could have used, say, $10,000 more ($25,000 total) to buy more equipment or pay off more of his loan. He would have ended the year with only $20,000 ($45,000 total cash available minus $25,000 used for investing and financing activities)—which is less cash than the $25,000 he had at the end of year 1.
Would ending the year with less cash than he started have made Austin a bad manager? Not at all. He would have simply made a business decision that it was more important to his future operations to acquire assets, pay back the loan, and repay his investor. And because he generated more cash from operations – greater cash flow – in his second year ($20,000) than in his first ($15,000), Austin should be considered a good business manager, especially in a start-up enterprise.