Now we're going to look at how a profitable growing company can go bankrupt. In scenario one, we have steady sales. Let's take a look at scenario one in the spreadsheet, a handout I provided. Edgar's Roast Coffee is selling 25,000 pounds of coffee every month at $6 per pound at an average total cost $5 per pound for a net profit of $1 per pound. So it all sounds good. The PNL statement matches sales that are booked in January. $150,000 for 25,000 pounds at $6 per pound. To the variable costs of January production which are $100,000 plus January's share of the fixed costs. $25,000 total. $10,000 GMA expense. And $15,000 For one months' straight line depreciation of capital equipment resulting in a new profit of 150 minus 125 or $25,000. The cash flow statement represents the same events quite differently. Variable expenses of $100,000 and fixed expenses of $10,000 for buying and roasting 25,000 pounds of beans need to be paid for in cash in January. But the account receivable of $150,000 created in January is not paid in cash until April. In fact, no money at all comes into our business until April. But we still have the $110,000 cash expense triggered by February's order, that must be paid in February. And another $110,000 cash expense triggered by March's order that must be paid in March. Altogether we need $330,000 more cash before the first payment comes in in April. Already my $260,000 reserve of cash is not enough. So I rush around and borrow money from friends and family and in April, cash flow turns positive and the situation starts to improve. My original reserve of $260,000 was at least $70,000 too small. Assuming that I can get the extra money together in time to buy beans in March and stay on schedule, cash flow does turn positive in April with a net of $40,000 coming in. But I can't pay back that extra emergency $70,000 that I needed until May. The positive cash flow position develops slowly. By December, when I already have $300,000 in net profits on paper, I still have $510,000 less cash on hand than I had before I started the business. Although cash flow turned positive in April, it still takes me until January of year 3, 25 months after launch of my company to recover my original $800,000 cash investment. Now we'll consider scenario two when I have rapid sales growth. It turns out Edgars Roast coffee is a hauge regional and then nationwide success. The orders we receive are literally doubling every quarter. 25,000 pounds per month for January through March, then 50,000 pounds for April through May, 100,000 pounds for June through September, 200,000 pounds for October through December, and so on. So let's look at the scenario two. Profit and loss statement first. Under scenario 2, when our sales increase from 25,000 to 50,000 pounds in April, profits more than double. From $25,000, or $1 per pound on a 25,000 pound order to $75,000, or $1.50 per pound on the much larger 50,000 pound order. The reason why our marginal profits, profits per units of production, increase is that when the number of beans we process doubles, only the variable costs vary. They increase by $4 for every pound of additional production. But our fixed costs, the general and administrative expense and depreciation, are fixed. They stay the same when we produce more so the accounting allocation of $25,000 in fixed costs to total pounds of beans drops from $1 per pound at 25,000 pounds to $0.50 per pound at 50,000 pounds production. Rising marginal profits on higher sales and production volumes are typical in most businesses and are known as economies of scale. The lower a product's variable cost, relative to its fixed cost, the greater the economies of scale. This is why internet businesses, where variable costs are often little more than the cost of electricity, have such dramatic economies of scale. According to our projected profit and lost statement, this pattern continues by the time we are selling 200,000 pounds of beans while our variable costs remain $4 per pound, our fixed costs are now only 12 and a half cents per pound for a total cost of $4.12 and a half cents per pound and a total profit of $1.87 and a half cents per pound. Under this rapid growth scenario by the end of year one, we have sold 1,125,000 pounds of Edgars Roast Coffee and made a theoretical net profit of $1.95 million. But now let's take a look at how scenario two plays out in our cash flow statement. Unfortunately our cash flow statement. Which reflects the true timing of cash moving in and out of our company paints a very different picture than our PNL. Under the scenario one cash flow, $110,000 in cash went out the door in April to process 25,000 pounds of beans, but we also received $150,000 cash in April. Finally getting payment for the 25,000 pounds of beans that we had processed and delivered back in January. This cash influx saved us from needing to borrow any more money, but now in scenario two. Because the customer has put in a new, higher order for April of 50,000 pounds, we need to spend $210,000 cash instead of $110,000 cash. So cash flow stays negative, and our emergency borrowing is now up to $130,000. May and June are going to be just as bad for cash flow. We're going to have $60,000 negative cash flow each month until July when we finally start receiving cash for the larger orders that started in April. Gotta hang on until July. Unfortunately in July we receive an order not for 50,000 more, but for 100,000 more pounds of beans. Instead of the $90,000 positive cash flow we expected, $300,000 cash in as payment for the 50,000 pounds of beans we produced in April. And $210,000 cash out to produce another 50,000 pounds of beans. We face a further $110,000 negative cash flow. $300,000 cash in as payment, as we mentioned before, but $410,000 cash out to produce another 100,000 pounds of beans. Now I start to panic. My emergency borrowing is up to $360,000 with no end in sight. Maybe I can hang on until October when we will receive the first of the larger $600,000 cash payments. By the end of September I owe my friends $580,000 on top of $800,00 of my own money. I'm nearing the limit of what they can do to help me. Then catastrophe strikes. At the beginning of October we receive a new larger order for 200,000 pounds of beans. Each month for three months. Now I get my Excel spreadsheet model out. And I begin plugging in the expected orders and expected cash flows, and it becomes clear that to survive until the end of December, we will need a total of $2,010,000 in cash. My $800,000 plus an additional 1.21 of borrowing. That is more than I can raise from my friends and family. Beans keep arriving that we can't pay for. We face financial penalties from the grocery chain if we fail to deliver on the full amount that they have requested under the terms of our supply contract with them. So if we fail to deliver 200,000 pounds of beans in October, they can withhold the $600,000 payment for the 100,000 pounds of beans that we delivered back in June. And so on. The gaping hole appears to be getting larger and larger. If their orders keep doubling every quarter, it's now become clear to me based on my spreadsheet analysis, that when we will need close to $5 million more cash than we have by June of next year. Perhaps, if I had understood this negative float problem better before launching the business, I could have arranged what is called accounts receivable financing or factoring, a short term loan against accounts receivable. But these things take time to arrange and we're unable to pay our bills right now. The fuel company isn't paid and stops delivering fuel to power the roasters. Workers stop coming to work because we can not pay them. The company is bankrupt. And can't even be reorganized. Having broken our contract with our buyer we owe them large cash penalties. In our now severed relationship with them was the company's only distribution channel. The lights go out on [Edgars Roast Coffee. Yet, from a financial accounting point of view, every transaction we did was profitable. How do we somehow been able to come up with the mountains of cash needed. We would have had a profit of 1.95 million our very first year. Now you know at least one way that profitable companies can go bankrupt.
