Financial Statements in Government: A Compliance and Liquidity Approach

Stories relating to chapter III of Financial Reporting in Government
By Dr. John Sacco , George Mason University
Revised Saturday, April 12, 1997

A vendor who sold hats with fancy emblems was doing so well that he thought he'd invest in a machine to press on the emblems instead of buying the hats with the emblems. In the first three months he took in (grossed) $10,000. The hats only cost $3,000 so he had quite a bit of cash. Some of this went to pay other expenses, which amounted to 1,000. This meant he was making about 2,000 per month. The machine would cut the cost of by 10%. The machine itself costs 6,000 since it could press the emblems, block the hats, and even clean them. The vendor asked a friend to do an income statement for the quarter.

                    Income Statement
  sales                10000
  cogs                  3000
  gross margin          7000
  operating             1000
  net profit            6000

The vendor did not save any of the profits assuming business would get better and the continued profits would pay for the machine. A lender charged 12% or 1% per month on the declining balance.

           rate=           0
  month    balance  interest principal
         1     6000       60      500
         2     5500       55      500
         3     5000       50      500

The income statement for the next was:

  sales                 3000
  cogs                   900
  gross margin          2100
  operating              333
  interest                60
  net profit            1707

From the net profit, the vendor was easily able to pay the principal for that month of 500 and still have decent cash for himself. Much to the surprise of the vendor, another person starting selling similar hats, which cuts the vendor's business in half.

  sales                 1500
  cogs                   450
  gross margin          1050
  operating              167
  interest                55
  net profit             828

While he was able to pay the principal for the next month he has very little to live on. He wished he had saved some the initial money he made to help pay for the investment in the machine. He also wished that he had anticipated the competition and down turn in revenues. He realized that when you borrow, you need a regular savings plan to pay back the money and of course adequate revenue to permit savings.

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