Medieval Adventures Company |
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Finance/Financial Management |
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Financial Accounting |
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Beginner |
2 |
Available.
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$9.00
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Medieval Adventures Company was founded by Aaron Reinholz to produce a game marketed under the name Castles and Unicorns. Each game cost the company $35 to produce. In addition to these production costs that varied in direct proportion to volume (so-called variable costs), the company also incurred $10,000 monthly “being in business” costs (so-called fixed costs) irrespective of the month’s volume of activity. The company sold its product for $55 each.
As of December 31, Reinholz had been producing Castles and Unicorns for three months using rented facilities. The balance sheet as of that date is shown below.
MEDIEVAL ADVENTURES COMPANY Balance Sheet as of December 31
Assets Liabilities & Equity Cash $146,250 Accounts receivable 68,750 Common stock $250,000 Inventory 35,000 Retained earnings 0 Total $250,000 Total $250,000
December sales had been 730 units, up from 500 in November, enough to report a profit for the month and to eliminate the deficit accumulated in October and November. Sales were expected to be 1,000 units in January, and Reinholz’s projections showed sales increases of 500 units per month after that. Thus, by May, monthly sales were expected to be 3,000 units. By September that figure would be 5,000 units.
Reinholz was very conscious of developing good sales channel relationships in order to increase sales, so deliveries of Castles and Unicorns were always prompt. This required production to be scheduled 30 days in advance of predicted sales. For example, the company had produced 1,000 games in December for January sales, and would produce 1,500 in January for February’s demand. The company billed its customers with stated terms of 30 days net, but did not strictly enforce these credit terms with the result that customers seemed to be taking an additional month to pay. All of the company’s costs were paid in cash in the month in which they were incurred. Reinholz’s predictions came true. By March, sales had reached 2,000, and 2,500 units were produced in March for April sales. Total profit for the year by March 31 had reached $60,000. In mid-April, to get a respite from the hectic activities of running the business, Reinholz went on a family vacation. Within a week the company’s bookkeeper called. Medieval Adventures’ bank balance was almost zero, so necessary materials could not be purchased. Unless Reinholz returned immediately to raise more cash, the entire operation would have to shut down within a few days.
Assignment
1. Prepare monthly income statements, balance sheets, and cash budgets based on sales increases of 500 units per month and 30-day advance production for January through October. Try to set this up on a spreadsheet so you can do some sensitivity analyses.
2. Prepare a statement of cash flows (SCF) for the months of March, May, and August. Be sure that each SCF shows the same results as your cash budget for the month.
3. How is it possible that a company can begin with $250,000 in capital, have profitable sales for a period of six months, and end up with a zero bank balance? How could this situation have been avoided? Use your spreadsheet from Question 1 to test some possible alternative approaches that might have been taken to manage the company’s cash.
4. What advice would you provide to Mr. Reinholz when he returns from vacation?
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